University of Southern California

The Real Pros and Cons of Equity Trading in the 21st Century
July 15, 2011
Finance and Business Economics

Over the last 25 years, technology has transformed how financial markets operate. Floor-based markets have given way to electronic brokers, exchanges, and dealers. Trading is now incredibly fast. So much so, some observers worry - especially in the wake of the May 8, 2010 Flash Crash - that the age of computerized equity trading may introduce unanticipated problems.

"In some cases, innovative trading systems are so different from traditional ones that many political leaders and regulators do not fully appreciate how they work or the many benefits that they offer to investors and to the economy as a whole," says USC Marshall Professor Lawrence E. Harris. Harris and his colleagues James Angel and Chester Spatt address these concerns in a new published article, "Equity Trading in the 21st Century," that appears in the Quarterly Journal of Finance.

We can forgive skeptics their concerns - terms like dark liquidity pools, hidden orders, flickering quotes, and flash orders don't exactly sound investor-friendly. But Harris and his colleagues show that recent innovations were driven by investor demand, and are largely positive. Here's why:

  • Computerization removes the need for human intermediation, and with it, the many problems associated with dealers and brokers who too often were inattentive, lazy, mistake-prone, or dishonest.
  • The costs of trading fell dramatically as efficient computer systems replaced labor-intensive trading processes. These cost savings improve the performance of individual and institutional investors.
  • Innovations like the ominous-sounding dark pools—which limit dissemination of proprietary trading information—actually allow investors to do what they've always done, except more efficiently. For example, large traders always avoid exposing full sizes of their orders to prevent others from front running them. They once used floor brokers to manage their order exposure and hoped that their brokers could play poker well. Now they use dark pools run by computers that never inadvertently or intentionally leak information.

While these elements create remarkable liquidity, the system is not perfect. "Markets need better safeguards against meltdowns caused by programming errors," they note. "Market orders, which contributed significantly to the Flash Crash, should not be permitted in electronic systems." Further, "brokers should be prohibited from front running their client orders by trading correlated securities."

Harris and his coauthors argue that regulators need to understand the clearly actual strengths and weaknesses of electronic trading to avoid unintentionally damaging the trading ecosystem. For example, "even a small transactions tax on trading would seriously reduce liquidity because the margins on which liquidity-providing electronic traders operate are so small."

The Bottom Line: Despite concerns raised by many commentators, recent innovations in trading systems have greatly reduced individual and institutional investor transaction costs.

Larry Harris is the Fred V. Keenan Chair in Finance, Marshall School of Business, University of Southern California and former Chief Economist and Director of the Office of Economic Analysis, US Securities and Exchange Commission. Learn more about Professor Harris and his research here.