Key executives from Charles Schwab Corp (NYSE:SCHW), a firm catering to mom and pop investors that advertises trust and stability, have issued the most damning indictment of high frequency trading yet, calling the practice a “cancer” on the markets.

charles schwab

“High-frequency trading has run amok and is corrupting our capital market system by creating an unleveled playing field for individual investors and driving the wrong incentives for our commodity and equities exchanges,” said firm Chairman Charles Schwab and President and CEO Walt Bettinger in a statement.  It is interesting to note the commodity exchanges, which are the behind-the-scenes powerhouses driving the lobbying effort to keep the HFT establishment in place, were called out in the statement before the equity exchanges, who have become significantly weakened forces over the past three years as their grip on trading volume and power has been diluted.

Schwab: HFT is gaming the system

“High-frequency traders are gaming the system, reaping billions in the process and undermining investor confidence in the fairness of the markets,” the statement said, making what can be argued is the boldest comments to date but also echoing behind the scenes comments that have been reported in ValueWalk before the publication of Flash Boys. “It’s a growing cancer and needs to be addressed.”

As previously discussed in ValueWalk, HFT firms have been accused of understanding how the market making software works and placing “fake” orders to influence the market price.

Schwab statements fly in the face of arguments that HFT doesn’t matter to retail investors

Arguments in favor of HFT presented in the media have, in part, dismissed criticism because they say it doesn’t impact average investors.  Although Schwab is said to benefit from HFT rebates, the statement from an icon of average investors seems to disagree with HFT proponents. “If confidence erodes further, the fuel of our free-enterprise system, capital formation, is at risk,” the statement read. “We can’t allow that to happen.”

Former Senator Kaufman echos Schwab statement

When the statement was released it immediately generated buzz.  Speaking on CNBC this morning, former US Senator and financial reform advocate Ted Kaufman, noting the Schwab comments, said that anything effecting the credibility of US markets must be addressed. “Free markets are what makes this country great,” he said.

“The United States capital markets have been the envy of the world in creating a vibrant, stable and fair system supported by broad public participation for decades,” the Schwab statement said. “Technology has been a central part of that positive story, especially in the last 30 years, with considerable benefit to the individual investor. But today, manipulative high-frequency trading takes advantage of these technological advances with a growing number of complex institutional order types, enabling practitioners to gain millisecond time advantages and cut ahead in line in front of traditional orders and with access to market data not available to other market participants.”  It is interesting to note the ability of HFT traders to “cut in line” ahead of other traders has been noted, which is expected to be a major issue.

“High-frequency trading cancer is deep,” the Schwab statement said. “It has become systematic and institutionalized, with the exchanges supporting it through practices such as preferential data feeds and developing multiple order types designed to benefit high-frequency traders. These traders have become the exchanges favored clients; today they generate the majority of transactions, which create market data revenue and other fees.”

The Schwab statement was now pointing at the primary supporters of HFT who are said to be coordinating and influencing the media debate in a “war room” like atmosphere.

“High-frequency trading isn’t providing more efficient, liquid markets; it is a technological arms race designed to pick the pockets of legitimate market participants,” the statement said, directly contradicting statements from HFT advocates, noting the practice flies in the face of the markets’ founding principles. “Historically, regulation has sought to protect investors by giving their orders priority over professional orders. In racing to accommodate and attract high-frequency trading business to their markets, the exchanges have turned this principle on its head.”

Order types called out

After tagging the exchanges with perhaps the most harsh confrontation to date, the Schwab statement took aim at a critical point in the debate.  “Through special order types, enhanced data feeds and co-location, professionals are given special access and entitlements to jump ahead of investor orders,” the statement said, pointing to issues that could be considered in a solution. “Last year, more than 95 percent of high-frequency trader orders were cancelled, suggesting something else besides trading is at the heart of the strategy.”

Virtu considered

Then in a tip to Virtu, the statement then considered the unheard of statistical win percentage.  “Some high-frequency traders have claimed to be profitable on over 99 percent of their trading days. Our understanding of statistics tells us this isn’t possible without some built in advantage. Instead of leveling the playing field, the exchanges have tilted it against investors.”  As we have pointed out in previous ValueWalk articles, the average win percentage in trend following, the most popular algorithmic trading strategy, is historically just north of 54%.

“Time to treat the cancer aggressively”

The Schwab statement ended as strong as it started, saying: “The integrity of the markets is at the heart of our economy. High-frequency trading undermines that integrity and causes the market to lose credibility and investors to lose trust. This hurts our economy and country. It is time to treat the cancer aggressively.”