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Totally automated “high-frequency trading” is part of the stock market right now — a big part.According to some estimates, high-frequency trading by investment banks, hedge funds and other players accounts for 60% to 70% of all trades in U.S. stocks, explaining the enormous increase in trading volume over the past few years. Profits were estimated at between $8 billion and $21 billion in 2008.

Some market observers, members of Congress and regulators are worried. Are those profits coming out of ordinary investors’ pockets? Is Wall Street’s latest qet-rich-quick scheme going to harm innocent bystanders? “I don’t think it would hurt people to become educated as to the intent of these strategies,” says Wharton finance professor Robert F. Stambaugh. “What is their effect on the markets? There is a little sense of 2001: A Space Odyssey [in that it] does kind of create an air of mistrust.”Its defenders say high-frequency trading improves market liquidity, helping to insure there is always a buyer or seller available when one wants to trade. And so far, high-frequency trading doesn’t look threatening, according to several Wharton faculty members. Indeed, it may well provide benefits to mutual fund investors and other market participants by reducing trading costs. But at the same time, several note that not enough is known about how trading at light-speed works, whether it can be used to manipulate markets or whether benign-looking moves by different players could interact to produce a new financial crisis.

“High-frequency trading involves investors with good computers taking advantage of small discrepancies in prices,” says Wharton finance professor Marshall E. Blume. “Generally, economists think that drives prices back to where they should be…. If they bring liquidity to the market and make prices more accurate, then that’s good. Now a concern, which is hard to document, is that somehow these traders manipulate the market, which would be bad.”Turning decision-making over to machines has not always benefited humans, notes Wharton finance professor Itay Goldstein. “People believe the crash of ‘87 was caused by this kind of computer-based trading.” In that case, a vicious cycle swirled out of control as computerized trading programs dumped stocks in response to falling prices, causing other programs to do the same.

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