With the immediate furor over Michael Lewis’s book, “Flash Boys”, finally dying down, many market players are hoping the receding hype gives way to a discussion of the real problems and possible solutions to some of the issues the book brought up-problems that have much more to do with lack of regulatory enforcement and evolving market structure than with high-frequency trading (HFT).
Still, with the U.S. Congress, federal regulators and the Department of Justice all scrutinizing the practice of high-frequency trading, the fallout of all this may be far from over. Since the book’s release in early April, the HFT industry has seen class action lawsuits filed, new HFT regulations approved by the European Union, one high-speed trading firm indefinitely postponing its IPO, and previously announced investigations by the DOJ and the New York Attorney General’s office jumping back into the headlines.
By almost any measure, the atmosphere surrounding HFT over the past few weeks has felt toxic. A new survey by ConvergEx Group LLC, found that 70 percent of financial industry participants said the U.S. equity markets aren’t fair for all, and 51 percent said high-frequency trading is harmful or very harmful to the market and investors.
“Look, no one is going to ban high-frequency trading, but I think there could be a real discussion on the structural changes this market needs to make,” said Joe Saluzzi, a partner at agency brokerage Themis Trading and frequent critic of high-speed trading. “At least now people are starting to talk about all the right things, even though it took years and Michael Lewis’s book to do it.”
Indeed, in this environment, it’s not surprising that many market players fear that the coming wave of possible Congressional hearings, more class action lawsuits, prosecutorial investigations and new regulations cannot be stopped.
The Coming Regulation: A Flood or a Trickle?
It is unlikely that April 2014 is going to go down as high-speed traders’ favorite month. After the publication of “Flash Boys” and its subsequent promotion at the beginning of the month, the industry has been under fire, being blamed for everything from nicking Mom and Pop investors for spare change on their stock trades to blatantly rigging the markets.
Unsurprisingly, the piling-on of government regulators and prosecutors, members of Congress, plaintiffs’ attorneys, and all sorts of market participants — many of whom were finally seeing their years of alarm-sounding gain traction — began in earnest shortly thereafter. Now, the Commodity Futures Trading Commission, the Securities and Exchange Commission and the Federal Bureau of Investigation are all examining the industry in some manner, making it highly unlikely that nothing will be suggested as to new rules or that no criminal charges, in the case of the FBI, will be forthcoming.
“That book has caused quite a media buzz, and of course, while not all high-speed computer trading is nefarious, the temperature certainly has been turned up,” said Prof. James J. Angel, a visiting professor of finance at The Wharton School of Business at The University of Pennsylvania.
In mid-April, when the NYAG’s office issued subpoenas to six HFT firms, it showed the industry that New York State Attorney General Eric Schneiderman wasn’t backing off his pledge made a month prior to look into some of the HFT industry’s practices. For example, Schneiderman — who has riled high-speed traders by labeling some of their tactics “insider trading 2.0” — is expected to look into the practice of “latency arbitrage,” or trading off the pricing differential caused by millisecond delays in the posting of trading information by different venues or exchanges.
“I think we’re unlikely to see a populist overreaction here, but it was important for regulators to come out and say, yes, we’ve been looking at this situation,” said Dave Lauer, president and managing partner of KOR Group LLC, a consulting and lobbying firm that focuses on market structure and technological trends in the financial services industry. “Many of these have been long-term investigations.”
And then there are the lawsuits. First, a suit was filed against CME Group, Inc. — owner of the Chicago Mercantile Exchange and the Chicago Board of Trade — over allegations the company allowed high-frequency traders an early peek at its order info. The suit, which is seeking class action status, was brought by three CBOT floor traders.
Not long after, the city of Providence, R.I. launched a wide net, suing dozens of U.S. stock exchanges, brokerages and HFT firms in a lawsuit that accuses them of market manipulation and other securities crimes. The suit, which is also seeking class action status, was brought by plaintiffs’ firm heavyweight Robbins Geller Rudman & Dowd LLP.
Citing many of the same practices outlined in Lewis’s book, the Providence lawsuit claims that the collusion of the exchanges, brokerages and HFT firms resulted in the transfer of “billions of dollars annually from buyers and sellers of securities to themselves.”
Prof. Angel said he expects there to be more of these lawsuits before this is all over. “There’s a saying, ‘Where there’s a hit, there’s a writ.'”
Market Structure Debate
While many market participants don’t disagree that some of the problems with the market need to be addressed, they are worried that regulatory overreach, congressional zeal and pending lawsuits could derail what might be the financial services industry’s best chance to have a serious discussion about market structure, which many agree is at the heart of the most serious problems being raised.
Indeed, the conditions to allow this conversation to happen are now coming into focus, they insist, and it would help if everyone just calms down and stops quoting passages from “Flash Boys.”
“We’re getting to a period now where it has quieted down from the initial reaction to the book,” said Peter Nabicht, a spokesman for Modern Markets Initiative, an HFT industry lobbying group. “I think the hyperbole has decreased, and we can begin to have the substantive discussion on market structure that is needed.”
That discussion could begin with conducting the SEC’s planned pilot programs of the maker/taker rule and tick-sizes, and possibly including a trade-at aspect on both, according to several market participants interviewed by Traders. Others contend the entire concept of payment-for-order-flow should be re-examined. And don’t even get them started on Reg NMS.
“It’s hard to know how Reg NMS even works since it’s never really been enforced,” said Eric Hunsader, the founder of market-data provider Nanex LLC. Reg NMS was established in 2007 to modernize the exchanges, encourage competition, and ensure investors would receive the best price executions.
What happened instead, critics say, was the proliferation of dark pools, data stream stall-outs and the somewhat unsavory practices between exchanges and the traders-in many cases, high-frequency traders-to gain that millisecond advantage. No wonder all this has some brokers and institutional traders scratching their heads over the complexity, murkiness and unsteady navigability of today’s trading markets.
“In a sense, the SEC has no business creating new regulations, unless they are going to start enforcing Reg NMS and the address the discrepancy between the SIP and the data feeds,” said Hunsader.
Hunsader described how the miniscule time difference between when a securities’ price appears on direct data feeds paid for by high-frequency trading firms and when it appears for the rest of the trading public on the SIP, just hundredths or even thousandths of a second later, is usually enough of a differential for HFTs to trade on. It’s a concept the NYAG is reportedly already looking into. “It’s like creating an instant overcharge,” Hunsader said. “And then it’s just rinse and repeat.”
The very first thing regulators should do is make sure that pricing information arrives at the SIP as fast or faster as it does to the direct data feeds-a requirement that’s at the very heart of the what Reg NMS was meant to do, Hunsader said. “Let’s do that for six months, and see what else get corrected by doing that.”
What the SEC Could Do Now
The SEC’s much-talked about plan to hold a pilot program to eliminate the maker-taker pricing on some securities, thus allowing brokers to pursue best execution for clients instead of best rebate for themselves, is one way regulators could examine what for some has become a problematic conflict in equity trading.
“There are a lot of inherent conflicts of interest, with brokers and with SROs,” said KOR’s Lauer. “It’s everywhere you look-and if we want to re-examine the foundation of the markets, we have to look at some of these conflicts.”
The SEC has said it is moving forward on conducting a pilot program to first examine tick-sizes, perhaps widening the trading on certain stocks to five-cent increments instead of one-cent. In testimony to the U.S. House Financial Services Committee on April 29, SEC Chair Mary Jo White outlined budget priorities for 2014, and reiterated the SEC’s plans to conduct the tick-size pilot program. In mid-April and at the height of the “Flash Boys” fury, the SEC also said it was looking into conducting a pilot program to examine maker-taker rules. An SEC spokesperson declined any further comment on the timing of either pilot program.
Indeed, the pilot programs have generated a lot of hopeful talk, mainly because any movement or study by the SEC is seen as a step in the right direction. “For a long time, the SEC has taken a hands-off approach on trading, watching and letting the market sort of do what it wants,” said Thomas O. Gorman, a partner at the law firm Dorsey & Whitney. Gorman also writes SEC Actions, a widely-read blog that covers securities regulation. “So, it may take them a while to pick this apart because trading has become very complicated and complex.”
That said, the SEC could enact other fixes that might be easier to implement. For example, Lewis’s book makes tremendous hay about traders who move their computers closer to the exchange server they want to trade against, with the idea that the HFT firm will glean trading data faster than others. If the SEC wanted to address that perceived problem, it would be relatively simple to do so, said Gorman. “Since the SEC regulates the exchanges, they could write a simple rule that says, you have to put up a filter or whatever other product to make sure everybody gets access at the same time, no matter where they are located.”
The SEC has to be cautious however, Gorman cautioned, because you don’t want to penalize innovation or stifle technological development. “Everybody is supposed to have a level playing field — but the other side of the level playing field is that everybody is encouraged to look for an edge, to get better research, better information, and better execution,” he said, adding that if a trader is just benefiting from getting better execution or has better access to data, it becomes a real fundamental question of whether you want to regulate that.
The Path Ahead
Naturally, the “Flash Boys” moment was bound to pass — and to some degree it has. However, market participants are now left with the question of what to do with the issues that have been brought up and the public perception that has, perhaps unjustly, linked certain traders’ behaviors with rigged markets.
If in the coming weeks it looks like fears of radical regulatory overhaul are unlikely, the lawsuits don’t find much footing in the courts, and Congress moves on to the next hot-button issue, then some market players may breathe easier, relieved over a bullet dodged.
But perhaps others will prevail and force the conversation of real market structure reform that they insist the future health of the U.S. financial markets needs to have in order to survive. “The market works well, and definitely works much better than it did 15 years ago,” noted KOR Group’s Lauer. “But it’s not enough that the market is better by some degree-we need to be looking at how we think it should be.”
