PrintThis week both the SEC and the FSA disclosed steps that could lead to restricting certain practices related to high-frequency trading. According to Bloomberg News, the FSA is meeting with market participants including hedge funds, banks, investment banks, and investment managers to assess the overall impact of high-speed trading in the UK. Yesterday, Senator Schumer announced that Mary Schapiro at the SEC had promised to attempt to enact a U.S. ban on flash orders, one type of high-speed trading in which major firms have a fraction of a second to react while orders are passing through “dark pools” prior to being routed to open public markets. That promise builds upon a speech in June, in which she pointed to a potential “danger that significant private markets may develop that exclude public investors” when announcing that the Commission was considering restrictions on high-speed trading.
The timing of the SEC investigation is in part a response to a letter to Chairman Schapiro from Senator Schumer condemning the practice as unfair, a part of which is included below.
Flash orders allow certain members of these exchanges to obtain access to order flow information before that information is made available to the public, allowing those members to use rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity. While pre-routing programs can benefit markets by providing additional liquidity, this kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions.
Besides any direct impact of potential regulations, the tenor of the discussion contains a significant message. The statements to date emphasize the priority that will be given to achieving fairness in the markets, including the relative weighting given to individual-level fairness over market efficiency in Senator Schumer’s letter. A similar view was expressed in an opinion by economist Paul Krugman in Monday’s New York Times, in which he questions how “traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve” the markets.
Although articles, including Paul Krugman’s op-ed piece, have focused on Goldman Sachs, NPR reported that the firm has sent a letter to its clients in which it denies engaging in-flash trading or any other programs where information from client orders is used before trades are completed, and revealed that all forms of high-speed trading together were responsible for only about 1% of 2009 revenues.
As reflected in that letter, it is important to bear in mind there are multiple types of high-speed trading; besides the specific mechanism described above for flash-trading, other programs simply rely on reacting to pricing more quickly to take advantage of market conditions. To put this into context, the Tabb Group published a study last year entitled “The Value of a Millisecond” (link to the catalog entry, not the $3,000 study) in which they concluded that an electronic brokerage firm would lose 10% of its revenues for each 10 millisecond increase in transaction latency.
We believe that one of the key longer-term lessons in all of this comes from the Goldman quote in the NPR article stating that “the most significant challenge ahead is for the regulatory framework to keep current with the rapid pace of innovation in the marketplace.” It will be important for regulators to keep this in mind as they craft regulations to deal with the perceived issues arising from today’s technology.
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