Wall Street needs a dose of common sense

Wall Street firms pride themselves on hiring the best and the brightest, yet they constantly do dumb things in pursuit of profits that bring the whole financial industry into disrepute.

The most recent example of Wall Street’s political and ethical blindness is the use of flash orders combined with high-frequency trading, wherein firms use super-high-speed computer programs to briefly post orders to buy or sell stocks.

This earns the firms rebates from the exchanges and allows them to determine the direction of the market quickly and trade ahead of less-fleet-footed investors, thus getting better prices.

To some observers, this practice is akin to front running, which is illegal. Proponents say that the flash orders increase market liquidity and help all traders get better prices.

The trouble is, the practice won’t pass the smell test for average in-vestors, if and when they become aware of it. Investors will likely think that they are being abused by investment firms with extraordinary computer power at their disposal.

Likewise, it is unlikely to pass the smell test with a skeptical Congress. Members of Congress could have a field day interrogating Wall Street bosses over its use and whether they have gained fortunes by taking advantage of the small investor.

As a result of the mess that the mortgage backed securities disaster helped create, Congress is already suspicious of, and even angry at, Wall Street.

The suspicion is apparently compounded by hedge funds’ use of naked short selling and naked credit default swaps, and the huge salaries and bonuses being paid to some of the same investment bankers who helped create the disaster.

The Securities and Exchange Commission has said it will investigate flash orders and high-speed trading.

It should carefully examine the extent of flash orders and high-frequency trading, and their impact on the market and all in-vestors. Only if the benefits to the whole market clearly outweigh the costs, should the practices be allowed to resume.

Likewise, the SEC should continue to study the extent to which naked shorting was used to drive down the prices of vulnerable stocks in last year’s market crash, while leaving the naked-shorting ban in place until there is clear evidence that naked shorting was “not guilty.”

In the same manner, the SEC should ban naked swaps until it can gather evidence on their role in the near collapse of American International Group Inc. of New York and several other swaps sellers during the crisis. If naked credit default swaps contributed to the seriousness of the crisis, the SEC must find a way to ban them and police the ban.

Financial market purists will argue that banning these tools will make the financial markets less efficient.

However, the financial markets will get a whole lot less efficient if Congress steps further into the regulatory arena than it already has. And that is a possible outcome if it is unhappy with the SEC’s efforts to restrain practices that Congress thinks are inimical to the well-being of most investors.