I like Mark Cuban a lot. I think he’s an awesome business mind and is really entertaining on Shark Tank (which happens to be my favorite show). Nothing in this article should be construed as an attack on Mr. Cuban, whom I respect a lot.

My Qualifications

Before we get into the nitty-gritty, it’s important to clarify that I feel uniquely qualified to talk about the subject of HFT. As an active day trader, I trade millions of shares of stock every single month. In fact, it’s no exaggeration to say that I trade more shares in a given day than most people will trade in their entire lives.

In the course of that trading, I am constantly doing business with high-frequency traders. Given their ubiquity in the current market environment, dealing with HFTs is unavoidable. Because of that, I’ve had to study HFT in great detail in order to stay competitive. Unlike the HFTs, I don’t have the same advantages of speed or automation like they do as my trading is completely manual (as opposed to automated).

Finally, unlike an employee at a HFT firm, I have nothing to gain through this line of argument. The discussed HFT rule changes will, in all likelihood, not affect me in the slightest. In fact, as I mentioned before, HFTs are my biggest competitors. I would probably stand to gain financially if HFT was outlawed tomorrow.

The Case For HFT

I’m going to first discuss the benefits of HFT before discussing Mr. Cuban’s attacks on it. HFTs, simply put, increase the liquidity of the marketplace substantially in a way that human market-makers couldn’t do. These liquidity benefits can be confirmed via a look at the average bid/ask spreads in the market as well as by qualified sources such as Gus Sauter, the former CIO of Vanguard, who estimates that HFT has cut transaction costs at the firm.

Just as automation has led to efficiency and cost savings in other industries, so too has it led to savings for the average investor as human market-makers have become obsolete. Now let’s run through Mr. Cuban’s claims, one-by-one.

Defending HFT

Cuban: “The only certainty in the software world is that there is no such thing as bug-free software. When software programs are trying to outsmart other software programs and hack the world’s trading platforms, that is a recipe for disaster.” 

While it may be true that there’s no such thing as bug-free software, the competitive nature of markets means that the weaker programs get destroyed by losing money so that the stronger ones may survive. Also, HFT’s aren’t trying to “hack” into the exchanges like some cheesy War Games ripoff. Cuban also doesn’t really elucidate the mechanism whereby HFT will surely lead to disaster.

Cuban: “And BATS couldn’t get their software right for their own IPO. Why? It should be easy. They’ve been doing IPOs in electronic markets for years. Why did it fail now? If they can’t get an IPO they completely control right, does anyone really think that the software that controls the hundreds of millions of human-free interactions a minute is really bug free and cannot fail?”

Cuban is right that the BATS and Facebook IPOs were debacles, but that’s not really the fault of HFTs. The reason those IPOs failed is because they couldn’t get the opening cross right, which is a different mechanism than standard trading because these IPOs use a single ECN to open trade in the stock. In standard trading, one can use multiple ECNs such that in the rare event one stops working, orders can be entered using an alternate ECN.

I do believe that Cuban is right that there is a remote chance of failure in any complex electronic system, but I don’t really see any viable alternative. Going back to writing out order tickets by hand and calling in orders to the floor is akin to using abacuses instead of calculators. Every large business in the world now depends on the cloud which has the same theoretical chance of failure as the markets, but the efficiency advantages more than make up for that remote chance of failure. The same holds true for the stock market.

Cuban: “How many times an hour are there failures across individual equities around the world because of software running algorithms battling each other for supremacy to make a profitable trade? We have no idea.”

We actually do have data on the number of times that trades fail or are broken on individual equities, as all trades are reported. In fact, you can even go to the NasdaqTrader.com website here to see whether systems are operating normally and to see if there are any regulatory notices about trades in particular stocks.

Given the number of trades that take place in a given day, the number of “failures” is astonishingly low. I would venture to guess that on most trading days, not a single tradehas to be broken via a regulatory announcement in the U.S. equities markets.

Cuban: “And that’s before we even get to the possibility of nefarious or sovereign hackers getting involved.”

The potential threat of hackers is certainly real, yet they could also attack any of our nation’s other major systems (defense, infrastructure, electricity) as they are all electronic now too. The only other alternative is to revert back to the 18th century and trade stocks hand-to-hand under the buttonwood tree as they used to do it. Furthermore, HFTs didn’t cause electronic trading, but rather arose in response to it.

Cuban: “And the argument is horrible for another reason. If you’re an investor you shouldn’t care if the spread widened by a penny, nickel dime or quarter. If you’re anything but a trader the change is of no impact to whether or not the company will be successful and create returns for investors. In fact, that anyone even considers this a valid argument is a red flag that the exchanges are more interested in traders than investors.”

Liquidity benefits everyone, including investors (who pay less each time they buy and sell a stock) as well as public companies (who get to take advantage of the liquidity premium as public companies trade at higher multiples than private companies). Even if a company generates returns for investors, it doesn’t really matter if there’s nobody for an investor to sell his stock to without incurring significant transaction costs.

Cuban also inserts a false dichotomy between traders and investors, with the implication that only investors help companies raise capital via the public markets. In fact, the liquidity provided by short-term traders such as HFTs makes stock market investing more attractive (via decreased transaction costs), thus helping companies raise capital. If long-term stock investors had to wait days before buying or selling a particular stock, you could bet that stock market investing would dramatically decrease in popularity, thus hurting companies hoping to raise money.

Improving HFT

With all that said, I’m not so naive to think that all HFT is great for markets. A significant minority of HFT is what I term “predatory” in that it runs counter to the goals and interests of the market as a whole. HFT programs that provide phantom liquidity via rapidly entering and canceling orders do nothing to provide liquidity and unnecessarily tax the exchanges (who must deal with the quote traffic). Some HFTs make heavy use of “dark pools” of liquidity, trades that take place off the major ECNs and thus are difficult to track.

In order to deal with the nefarious aspects of HFT, I think it’s reasonable to regulate either the number of canceled orders vs. executed orders or perhaps institute a minimum time limit for entered orders to prevent excessive order cancellations. This would eliminate the phantom liquidity while preserving the liquidity benefits of HFT. Furthermore, attempts should be made to limit dark pool trading so that every trader can be on equal footing when it comes to executing orders.

This article originally appeared on TradeCrushers.com and is reproduced here with the kind permission of the author.