The technological arms race among professional equity traders threatens to destabilise US markets and more should be done to limit trading speed, according to New York attorney-general Eric Schneiderman.
His office is examining privileges, such as enhanced data feeds, that are marketed to high-frequency trading (HFT) firms.
Schneiderman said a new book by Michael Lewis, Flash Boys, helped to focus attention on the debate.
Two of Lewis’s earlier books – Liar’s Poker and The Big Short– highlighted Wall Street excesses. The latest book says speed traders are rigging the US market to make tens of billions of dollars.
“I would not be quite as hyperbolic as that,” Schneiderman said in an interview. “The race for speed is inherently dangerous. That leads people to take more and more chances to try to get an advantage, and that could lead to destabilisation.”
His inquiry threatens to disrupt a model that market regulators have permitted for years as high-speed trading and concerns about its influence have grown.
Trading firms pay to place their systems in the same data centres as securities exchanges. The practice – known as co-location – lets them shave millionths of a second off transaction times.
“We celebrate technology, but we have speed limits and airbags,” said Schneiderman, adding that the Securities and Exchange Commission (SEC) was taking a “hard look” at HFT.
Reining in market excesses was important “because we have lost a lot of credibility”, he said. “A lot of investors do not have confidence in the market.”
Lewis, a columnist for Bloomberg View, is adding his voice to a debate that has obsessed the securities industry for almost a decade while only periodically surfacing in public via events such as the May 2010 flash crash, in which the Dow Jones industrial average posted a loss of almost 1 000 points.
“The US stock market, the most iconic market in global capitalism, is rigged,” Lewis said in an interview on 60 Minutes on Monday. “It’s crazy that it’s legal for some people to get advance news on prices and what investors are doing.”
Everyone who owned equities was victimised by the practices, in which the fastest traders figured out which stocks investors planned to buy, purchased them first and then sold them back at a higher price, Lewis said.
HFT comprises a diverse set of software-driven strategies that have spread from US equity markets to most developed countries as computer power has grown and regulators have tried to break the grip of centralised exchanges. These traders usually employ super-fast computers to post and cancel orders at rates measured in thousandths or even millionths of a second to capture price discrepancies on more than 50 public and private venues that make up the American equities market.
Firms using these tactics account for about half the share volume in the US, a statistic that shows their pervasiveness and hints at the obstacles faced by proposals to rein them in.
Exchanges rely on HFT for profit as well as liquidity, with electronic market makers all but eliminating the old system of human floor traders who oversaw the buying and selling of equities.
While critics such as Lewis see a Wall Street plot, proponents say the new system is faster and cheaper.
In the US, the biggest high-speed traders include Virtu Financial, which filed last month to sell shares to the public. Bats Global Markets, the equity exchange that merged with Direct Edge Holdings this year, was founded by a high-frequency trader.
“We believe Lewis’s book can have a big impact on complex market structure issues that have been simmering for years,” Joe Saluzzi, the co-head of equity trading at Themis Trading and a frequent critic of the status quo in markets, said. “Hopefully, this type of publicity will finally force regulators to take action on issues that they’ve been sitting on for way too long.”
One of the heroes of Lewis’s book is Brad Katsuyama, who left Royal Bank of Canada in 2012 to form a new market, IEX Group, along with other former traders from the Toronto-based bank. IEX, which does not allow brokers to own stakes, has investors including David Einhorn’s Greenlight Capital as shareholders. Goldman Sachs is the biggest broker on the platform, which started trading in October last year and was established to minimise the influence of predatory strategies.
IEX was established partly to address concern that technological advances and fragmentation have made the $22 trillion (R232 trillion) US equity market too fast and opaque. The platform, which has ambitions to become an official exchange, imposes a delay of 350 microseconds, or 350 millionths of a second, on orders – enough to curb the fastest trading firms. IEX aims for greater transparency by making its trading rules available for public review, unlike some other electronic venues.
Lewis said on 60 Minutes: “I spoke to dozens of investors, big investors, famous investors who said that, ‘when Brad Katsuyama came into my office and laid out to me how the market was rigged, my jaw hit the floor. I mean, I knew something was wrong. I just didn’t know what it was and no one had told us.’”
Eric Ryan, a spokesman for the New York Stock Exchange (NYSE), and Nasdaq OMX Group’s Rob Madden declined to comment on Lewis’s claims.
“We disagree with allegations that the US equity market is rigged,” Bats president Bill O’Brien said. “While we should never stop trying to improve our market structure, it is unfair and irresponsible to accuse people simply because they use technology and enhance competition. This has helped make our market the most competitive and liquid in the world, greatly benefiting individual investors.”
Traders rushed to defend their strategies.
“While there are bad actors in every industry, the game is not rigged in the favour of professional traders who employ HFT to execute their strategies,” Peter Nabicht, a senior adviser to the Modern Markets Initiative trade group and former chief technology officer at HFT firm Allston Trading, said.
“Rather, they work hard to compete with each other to bring liquidity to the markets, benefiting average investors. Continued debate about the next evolution of market structure is needed and welcome, provided the debate is based on fact and resulting actions are reasoned, ensuring average investors continue to benefit from the transparency and efficiency enabled by inevitable technological advances.”
The practice of selling enhanced access to brokers accelerated as US exchanges evolved from member-owned firms amid a flurry of regulation and computer advances in the 1990s. Among other changes, the government-mandated compression of stock price increments to cents from eighths and 16ths of a dollar, a process known as decimalisation, squeezed profits for market makers and specialists that had overseen stock trades.
Faced with the need to maintain liquidity on electronic platforms where profits were too fleeting for humans to capture, exchanges encouraged computerised firms to post orders for investors to trade against. Co-location and customised data feeds developed alongside the hodgepodge of fees and rebates that market operators use to keep speed traders coming back.
“Part of what you’re seeing is people not understanding it, because they either haven’t taken the time or haven’t dug in,” Larry Leibowitz, the former chief operating officer of NYSE Euronext, said in a March 25 conference call with analysts. “It’s the responsibility of regulators to show leadership, to say, ‘We looked at these issues and we think these are fair. These are areas we want to improve and fine tune.’”
Market maker privileges have always been a hallmark of equity trading, starting with the sale of seats on the floors of exchanges. LaBranche & Co, created in January 1924, went public in August 1999. In papers prepared for its initial public offering, LaBranche disclosed that it regularly turned about 71 percent of sales into profit before paying its managing directors. Earnings before that expense climbed at least 25 percent every year from 1995 to 1999.
Results like those, as well as concern that the NYSE and Nasdaq were too powerful, helped spur reforms since 2000 such as decimalisation and a broader overhaul aimed at lowering barriers to trading. Through rules mandating that any order for stock be routed to whoever in the country was transmitting the best offer to buy or sell, regulators hoped competition among a much larger pool of de facto market makers would lower costs for investors.
That did happen. Buying 1 000 shares of AT&T before 1975 would have cost $800 in commissions, Charles Schwab, who founded discount brokerage Charles Schwab Corporation, told the US senate in February 2000. That was roughly 100 times more than the fees paid by some retail stock-pickers today.
Federal regulators have asked for years whether new restrictions were needed. In February 2012, Daniel Hawke, the head of the SEC’s market abuse unit, said the agency was examining practices such as co-location and the rebates that exchanges pay to spur transactions. Last year, the Commodity Futures Trading Commission announced a review of speed trading and sought industry input.
SEC spokesman John Nester declined to comment on Lewis’s book. He said the agency had undertaken a wide-ranging review of the equity market structure.
The regulator was “conducting a comprehensive data-driven analysis of a range of market structure issues, including HFT practices and their impact on the fairness, efficiency and integrity of our markets”, Nester said.
SEC commissioner Daniel Gallagher said on Friday that individuals were concerned that high-frequency traders detracted from fairness in the market.
“The problem with HFT right now is that there’s a perception that for the little guy, the markets aren’t fair. That perception to me is a reality. It’s something we need to address.” – Bloomberg