Is high speed trading the next Wall Street debacle?

A 9:30 am one August 1st, a software executive in a spread-collar shirt and a flashy watch pressed a button at the New York Stock Exchange, triggering a bell that signaled the start of the trading day. Milliseconds after the opening trade, buy and sell orders began zapping across the market’s servers with alarming speed. The trades were obviously unusual. They came in small batches of 100 shares that involved nearly 150 different financial products, including many stocks that normally don’t see anywhere near as much activity. Within three minutes, the trade volume had more than doubled from the previous week’s average.

Soon complex computer programs deployed by financial firms swooped in. They bought undervalued stocks as the unusual sales drove their prices down and sold overvalued ones as the purchases drove their prices up. The algorithms were making a killing, and human traders got in on the bounty too.

Within minutes, a wave of urgent email alerts deluged top officials at the Securities and Exchange Commission. On Wall Street, NYSE officials scrambled to isolate the source of the bizarre trades. Meanwhile, across the Hudson River, in the Jersey City offices of a midsize financial firm called Knight Capital,  panic was setting in. A program that was supposed to have been deactivated had instead gone rogue, blasting out trade orders that were costing Knight nearly $10 million per minute.  And no one knew how to shut it down. At this rate, the firm would be insolvent within an hour. Knight’s horrified employees spent an agonizing 45 minutes digging through eight sets of trading and routing software before they found the runaway code and neutralized it.

By then it was shortly after 10 a.m., and officials from the NYSE, other major exchanges, and the Financial Industry Regulatory Authority were gathering for an emergency conference call. It didn’t end until 4 p.m.  Business as usual?

A landmark study by Federal Reserve economists found that large U.S. banks enjoy a “too-big-to-fail” advantage in financial markets, joining a heated debate that could influence regulators that are implementing tough new rules for Wall Street.

The series of research papers, the U.S. central bank’s influential New York branch, suggests the biggest banks benefited even after the financial crisis from lower funding and operating costs compared with smaller ones. The researchers used data through 2009, which did not reflect post-crisis reforms. Fed economists also found that the biggest banks can take bigger risks than their smaller peers.

While the study did not pinpoint the reason big banks can borrow more cheaply, Wall Street critics say it is because investors believe the U.S. government would again rescue them in a panic.

The new research shows “it is improper to ask the taxpayer to underwrite the non-commercial banking operations of a complex bank holding company,” Dallas Fed President Richard Fisher, a long-time critic of big banks, said in an interview.

Fed economists estimated the funding advantage for the five largest banks over smaller peers to be about 0.31 percent, which they said was statistically significant.

The study did not look at whether the advantage persists as regulators implement the 2010 Dodd-Frank Wall Street law. Banks and their critics have been at loggerheads for years over whether the law did enough to prevent regulators from bailing out banks in a future crisis.

Rob Nichols, chief executive of the Financial Services Forum, which represents big banks, said the Fed researchers noted that the advantage could exist because big banks offer more products and can better diversify risk.

“They actually do say that the apparent cost of funding advantage could be attributable to the diversity and stability of large financial institutions,” Nichols said.

The Clearing House, an industry group for the biggest banks, published a study last week that was conducted by consulting firm Oliver Wyman. It found the difference in funding costs between large and small firms was negligible.

But skeptics in Congress still warn that the nation’s biggest banks like Bank of America Corp and JPMorgan Chase & Co. are still viewed as too integral to the U.S. economy to fail.

U.S. Senator Sherrod Brown, an Ohio Democrat, called The Clearing House study an attempt by banks to “protect the status-quo that requires hardworking taxpayers to pay for their risky activities.”

Limiting bank holding companies’ assets to no more than 4 percent of U.S. gross domestic product, as some have suggested, would increase industry-wide non-interest expenses by $2 billion to $4 billion each quarter.

Fed economists said regulators should focus on banks’ liabilities rather than trying to revamp their structure.

They suggested requiring banks to issue minimum amounts of long-term debt, also referred to as ‘bail-in’ debt. Under new U.S. rules, if a bank failed, its shareholders would be wiped out and holders of long-term debt of the holding company, or parent, would become the new shareholders.

The Federal Deposit Insurance Corp has said a bail-in stipulation would fit well with its plans for resolving failed banks. The Fed is considering writing the requirement.

Regulators could link the new requirement to banks’ use of risky liabilities such as uninsured deposits, repurchase agreements, or repos, or commercial paper, four New York Fed researchers argued in a separate paper.

Relying on those liabilities, which are subject to runs in crises, makes bank failures costly and threatens the stability of financial markets, wrote James McAndrews, head of research at the New York Fed, and three others.

If regulators forced banks to offset those liabilities with long-term debt, the firms would have less incentive to use risky funding sources, they said.

Now that the IRS has weighed in on Bitcoin, the faddish digital cash making recent headlines for bankruptcies at its exchanges, some users are celebrating, while others wonder if going legit will kill the new crypto-coin completely.  Under its new ruling, the IRS proposes treating the digital cash as an asset or commodity.

“We are very excited about this opinion,” says Erick Watson, chief operating officer of New Path Mining, a Bitcoin mining firm in Seattle, Wash. The most important reason, he adds, is what it says to the larger financial community.

“This decision legitimizes Bitcoin both as a transaction medium and as an asset,” Mr. Watson says. Bitcoin has been seen as a tool for illegal activity, he says. But this statement from a federal agency says that the government recognizes the currency and is working on strategies for how to treat it.

While the IRS opinion may be a boon to investors, it just added a boggling new burden on anyone who might want to use the virtual tender to actually buy something. Working out tax implications every time it’s used would prove highly impractical.

 One of the attractions of using Bitcoin in everyday life is its convenience and ease of use, says Arnav Sheth, assistant professor of finance at the graduate business school of Saint Mary’s College of California in Moraga.

Much like cash, Bitcoin can be transferred from one party to another quite easily and without much hassle. After the new IRS ruling, the accounting for it is going to become much more difficult, he adds.

Moreover, taxing Bitcoin as property can amount to double taxation. “Say you buy a sushi dinner for your family at an expensive restaurant for $600,” which at today’s prices is roughly one Bitcoin, says Professor Sheth. “If you paid $10 to buy that 1 BTC, you are now liable for taxes on the excess $590,” in addition to the taxes you pay to the restauranteur.

“There’s the troubling double-taxation aspect,” he adds. “You’re paying Uncle Sam twice: once for your Bitcoin and again for your dinner. In addition to that, it is now much harder for you to keep track of how much you will spend and how much you owe in taxes.”

Bitcoin backers say that these obstacles are not insurmountable, especially if Congress steps in to delay implementation of the ruling until the tech community can catch up.

The barter economy, or trading property for a product, is certainly not a new idea, says CPA Steve Brecher, senior adviser at WeiserMazars in New York. “There are more and more exchanges for different kinds of property,” he says, noting that the marketplace has worked out methods for determining quotations of value and doing the necessary calculations for reporting.

Moreover, with the high level of involvement from the tech community in the evolution of Bitcoin, the challenges of every day usage can be met, most likely with a new application or something similar, says Watson. “This is a tractable problem,” he adds.

However, given the lack of such software at the moment, the new ruling leaves the average user in a grey zone, says Steve Kirsch, CEO of Cointrust, a company that is developing technology to address the compliance and safety issues associated with virtual currencies.