Financial markets exist to transfer capital from investors to entities that need funding, as well as to provide liquidity for investors in the secondary market.

But buyers are often unavailable to purchase securities at the exact prices and at the exact time that sellers desire. This creates an opportunity for intermediaries to assume the risk of buying the securities, hoping to sell them later at a slightly higher price. This valuable function is called market making.

From the humble beginnings of market making under the buttonwood tree on Wall Street in 1792, stock exchanges have experienced many structural changes, including trading in decimals, a recent explosion in the number of trading venues that function like exchanges to 42 at last count, and a revolution of liquidity providers.

As a result, two independent sources calculate that total transactions costs on an “average” trade have declined from approximately 1.1 per cent a decade ago to a range of 0.33-0.64 per cent today. Investors have benefited tremendously, likely saving tens of billions of dollars annually.

In a world suspicious of everything Wall Street does, much criticism has been levelled at the practices of high-frequency trading and flash orders.

High-frequency trading involves positioning super-fast computers as close as possible to stock market servers to give some institutions the ability to buy or sell stocks in a fraction of the time it takes to blink an eye. By some accounts, high-frequency trading now accounts for about two-thirds of total stock market volume. Flash orders are orders that are instantaneously revealed to some high frequency traders before being made available to the wider public.

Much misinformation has been spread concerning high-frequency trading and related techniques. There is concern that an exclusive group of high frequency traders will be able to trade before others because of the information they obtain from flash orders and get better prices at the expense of retail investors. In reality, flash orders are only a small part of high frequency trading and the SEC has proposals to eliminate the practice. Vanguard has never allowed its orders to be flashed and all of the institutional investors we have spoken to claim that they also opt out of flash orders.

There is also the misperception that high-frequency traders are speculators who move markets to extremes. In fact, the vast majority of high-frequency trading involves looking for very small arbitrage opportunities, as between futures and cash markets or between the prices of exchange traded funds and their net asset values. These actions do not create volatile markets, they close gaps across markets and increase market efficiency. Indeed, in a different era, if market makers had computers with today’s computing power, their activity would have produced similar results.

In an efficient market, prices reflect information quickly, not slowly over time. Nathan Rothschild made substantial profits when his carrier pigeons brought him the first news of Wellington’s victory at Waterloo. Today, the information superhighway carries news far more swiftly than carrier pigeons. In a sense, telephones and telegraphs were their own earlier versions of high-frequency trading. Computers do the job even more quickly. The result is a more efficient electronic market that has marginalised the trading floor of the NYSE.

In their quest to find trading profits, competition among high-frequency traders also serves to tighten bid-offer spreads, reducing transactions costs for all market participants, both institutional and retail. Rather than harming long-term investors, high-frequency trading reduces spreads, provides price discovery, increases liquidity and makes the market a fairer place to do business.

Technology has dramatically improved the efficiency of our trading markets. Rather than putting the individual investor at a disadvantage, high-frequency trading cuts costs significantly for everyone. Individual investors are the ultimate beneficiaries when their pension funds and mutual funds can transact large volumes of trades anonymously with great speed and at lower cost.

As de facto market makers, high-frequency traders can exploit pricing anomalies and pick up pennies at the expense of other traders. Such activities are not sinister. The paradox of the efficient market hypothesis is that the people whose trades help make the market efficient must be compensated for their efforts. As former SEC Chairman Arthur Levitt has written: “We should not set a speed limit to slow everyone down to the pace set by those unwilling or unable to compete.” High-frequency trading networks let large and small investors enjoy a more efficient and less costly trading environment.

Burton Malkiel is Professor of Economics at Princeton University and the author of ‘A Random Walk down Wall Street’ and ‘The Elements of Investing’. This piece was co-authored by George U Sauter, Chief Investment Officer of the Vanguard Group

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