High-Frequency Trading: Who Knows What, and When?

May 15, 2014 11:27 AM
By Ted Oberhaus

No one’s asking for equal outcomes in the marketplace, just an equal footing at the starting gate.

A Trader's Perspective

If an exchange offers early access to market data to those willing and able to pay for it, is that a bad thing?

Not necessarily, some would argue. After all, exchanges are profit centers. Selling data is part of their business description. And if some investors invest more to generate a competitive advantage, what’s wrong with that? Many investors have the resources to acquire one type of edge or another in the markets.

We think that argument misses the point entirely.  And, apparently, so did the Securities and Exchange Commission (SEC).

In 2012, the SEC sued the New York Stock Exchange (NYSE) for violating Rule 603 of SEC Reg. NMS, which prohibits the practice of improperly sending market data to proprietary customers before sending that data to consolidated feeds that broadly distribute trade and quote data to the public.

“Improper early access to market data, even measured in milliseconds, can in today’s markets be a real and substantial advantage that disproportionately disadvantages retail and long-term investors,” said Robert Khuzami, director of the SEC’s Division of Enforcement, commenting on the lawsuit.

The SEC said the exchange had violated the rule for an extended period of time, beginning in 2008. The NYSE agreed to a $5 million penalty—the first-ever SEC financial penalty against an exchange—and significant undertakings to improve compliance.

Despite this single enforcement action (there have been no others), exchanges continue to sell market and trade information to high-frequency traders and other select clients at faster speeds of delivery than the public data feed.  And lawsuits claiming unfair advantage are piling up, the most recent of which pits a group of traders against the Chicago Mercantile Exchange and its Chicago Board of Trade.

None of this would matter to long-term investors who hold stocks for more than a fraction of a second, but for the games that high-frequency traders play with the data and its impact on the terms of the trade. (For example, by having fast access to data, high-frequency traders can anticipate order flow and get ahead of it. Recommended reading: "High-Frequency Trading: The Tricks of the Trade.")

Moreover, there is an element of unfairness about the practice that violates the spirit of another SEC rule, the Regulation Fair Disclosure. All investors should have access to the same data at the same time. Some are suggesting that what is going on between the exchanges and HFT is a bit like insider trading. Whatever the argument, we’ll leave that up to the legal experts. What we see is a game of "pay to play." No one’s asking for equal outcomes in the marketplace, just an equal footing at the starting gate. The elimination of proprietary data feeds, therefore, would be one of our recommendations to the SEC.

What do you think? Join us in the investment conversation.

Ted Oberhaus is a Lord Abbett Partner and Director of Equity Trading.

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Is there a reason why HFT's couldn't be required to register and act as official market makers? This would seem to help the situation.
A good question that requires an answer in two parts. First, high-frequency traders overseas are required to register as market makers under the Markets in Financial Instruments Directive (known as “MiFID”) under European Union Law. So there is regulatory precedence for such action. Second, here in the United States some high-frequency firms are registered as designated market makers (DMMs). But in our opinion, not enough HFTs are taking on this responsibility. Should they be required to? Well, the Securities and Exchange Commission (SEC) would find it easier to determine the causes of a crisis (such as the “Flash Crash”) ex post facto. But we have to assume that HFTs would rather not hand such information over to the SEC. So regulatory action may be necessary.
Doesn't HFT embody the very essence of George Orwell's "Animal Farm" where all animals are created equal, but some animals are more equal than others?