Re: The sad part is...
Mmmm, not sure I entirely agree with your view here.
are they adding anything to the functionality of the markets ? well, yes, they're providing a fast moving liquidy function - they're not forcing anyone to buy/sell at a price they dont want to, centralised counterparty exchanges dont allow that. where they go wrong ( and I think someone goes down this route lower down ) is that they induce a false feedback loop which moves the general market in an 'un-natural' direction.
So, if little Jonny Trader has a lump of BT in the market that he wants to sell at a specific price and he gets lifted, he still gets that price regardless of whether it's his mate repaying a LIBOR fix deal or SuperMegaTradingEngine jumping in before anyone else can grab it - there are no fingers in the wallet. If SuperMegaTradingEngine then gets lifted for 5 bps lower by EvilSuperMegaTradingEngine and they end in a death spiral up/down in the ladder, Jonny Trader still gets his bonus, he's not been done out of anything.
For exactly the same reasons govenors get put onto engines, market mechanisms need to be put in place ( where missing ) to halt/degrade automated electronic execution to stem the feedback. Trouble is, then you'll get into hide'n'seek games of 'my robot isn't really a robot at all'.
One of the earlier responders suggested a pre transaction tax, which might/might not be affective in slowing down the floodgate traders - trouble is you'd have to implement it everywhere and, as we saw with the UK not wanting to join in with various US/EU legislative initiatives, that's pretty hard to achieve.
Personally, I'd say let them go at it for exchanged traded centrally cleared instruments. if some one causes a flash crash, they're barred for a period of time and get fined to the amount equivent to the sum of losses incurred. one or two of them occuring and acually being implemented would move the hft chaps away from the gap scalping activities and into longer tem mean reversion models.
more than happy to be educated tho if I've got any/all of the above wrong.