[ by Larry Goldfarb ]

High speed trading are taking significant profits from traditional investors.  So says a report issued by the chief economist at the Commodity Futures Trading Commission, Andrei Kirilenko.  It says in a coming study that high-frequency traders make an average profit of as much as $5.05 each time they go up against small traders buying and selling one of the most widely used financial contracts.The agency has not endorsed Mr. Kirilenko’s findings, which are still being reviewed by peers, and they are already encountering some resistance from academics. But Bart Chilton, one of five CFTC commissioners, said on Monday that “what the study shows is that high-frequency traders are really the new middleman in exchange trading, and they’re taking some of the cream off the top.”

Mr. Kirilenko’s work stands in contrast to several statements from government officials who have expressed uncertainty about whether high-speed traders are earning profits at the expense of ordinary investors. The study comes as a council of the nation’s top financial regulators is showing increasing concern that the accelerating automation and speed of the financial markets may represent a threat both to other investors and to the stability of the financial system.

Mr. Kirilenko’s study focused on one corner of the financial markets that the CFTC oversees, contracts that are settled based on the future value of the Standard & Poor’s 500-stock index. He and his co-authors, professors at Princeton and the University of Washington, chose the contract because it is one of the most heavily traded financial assets in any market and is popular with a broad array of investors. Using previously private data, Mr. Kirilenko’s team found that from August 2010 to August 2012, high-frequency trading firms were able to reliably capture profits by buying and selling futures contracts from several types of traditional investors. The study notes that there are different types of high-frequency traders, some of which are more aggressive in initiating trades and some of which are passive, simply taking the other side of existing offers in the market.

Mr. Kirilenko, who is about to leave the CFTC for an academic position at the Massachusetts Institute of Technology, presented a draft of the paper at a CFTC conference last week. He said that the markets were a “zero sum game” in which the high-speed profits came at the expense of other traders. Mr. Kirilenko warned that the smaller traders might leave the futures markets if their profits were drained away, opting instead to operate in less transparent markets where high-speed traders would not get in the way.

Terrence Hendershott, a professor at the University of California, Berkeley, said there was a limit to the importance of Mr. Kirilenko’s work because it focused on profits and did not address the benefits high-speed traders bring.  Mr. Hendershott and many other academics have found that the competition between high-speed traders has helped lower the cost of trading for ordinary investors. But Mr. Hendershott said that limited data available to researchers had made it hard to determine whether the benefits outweighed the costs.

Regulators have said that devising new rules has been hard, in part because the trading world has become so complex, making it difficult to determine the total effect that all the innovations have had on traditional investors. Mr. Kirilenko said in an interview Monday that his study was intended to address that.

For more information, please read [Dealbook, 12/4/12].