It’s now been about a year since the furor following publication of Michael Lewis’s book Flash Boys: A Wall Street Revolt died down, and we thought we’d examine what happened in the interim to address the issues raised — particularly the willingness of securities exchanges to deliver information faster to those who pay for the right and to provide high speed traders with order types that allow them to jump in front of those who are slower. The answer is not that much. We thought we’d try to find out why.
The reason may be due in part, maybe in large part, to the changing nature of the national securities exchanges. Those exchanges historically operated as not-for-profit mutual organizations which were charged with enforcing market rules to protect investors. Whether it worked out that way is open to debate. The reality is that exchange members were able to use the system profitably, even though they might be compelled to make two- way markets, to the point of their own insolvency. The parties who profit are different now.
Over the last twenty years or so, the exchanges have abandoned their mutual organizational structure and become for-profit entities. The newer exchanges have never been mutual organizations. The structural change has altered the focus of the exchanges, whose chief concern is now growing their business. One of the ways the exchanges do so is by capitalizing on their control over market data. Their best customers are the high speed traders, which account for an estimated one-half of all securities trades. While that’s down from an estimated two-thirds in 2008, and while profits as well may be down, high speed traders still dominate the markets.
The exchanges have done nothing to discourage them. Quite the opposite. In competing for market share, the exchanges continue to offer high speed traders the right to preferred access to data feeds, the right to colocate their services within the exchanges’ servers and new order types customized to the needs of the traders.
A 2014 Congressional Research Service Report on high frequency trading1 acknowledges that the exchanges have been central to the existence and proliferation of high frequency trading. The Report also cited research which concluded that trading profits were being won by a small number of high speed trading funds. In an environment where trading profits are harder to come by, the traders who best exploit opportunities made available to them by the exchanges will be positioned to capture most of the gains. This despite the fact that those benefitting, unlike the exchange members, have no continuing obligation to make markets in times of market stress.
The SEC has been scrutinizing high speed trading for some time, but has yet to even define the term, let alone adopt a comprehensive regulatory scheme. Without a definition as a starting point, it will be difficult to preserve the benefits of high speed trading while curbing the abuses.
In contrast to the resistance of the stock exchanges and the hesitation of the SEC to address manipulative trading, the commodity exchanges and regulator have at least made an effort to deal with the issues. For example, Rule 575 of the CME Group Exchanges, effective September 15, 2014, and ICE Futures U.S. Rule 4.02, effective January 14, 2015, banned such predatory practices as spoofing, quote stuffing and closing-period market manipulations.
Whether these rules will succeed in cracking down on predatory trading remains to be seen. Both rules require proof of intent to engage in the prohibited conduct by the trader. Proving intent to manipulate the prices of commodities (or stocks) through circumstantial evidence will always be difficult. Such proof may be especially problematic where each trade is made by an automated, high-speed algorithm and the traders are uninterested in the fundamentals of whatever they are trading. What is more, the traders will often place the orders so that they can trade ahead of others and not to influence the price, which they do not want to move until after they have traded.
For its part, the Commodity Futures Trading Commission issued a “Concept Release on Risk Controls and System Safeguards for Automated Trading Environments,”2 asking a series of questions about whether today’s risk controls and automated trading were sufficient to match current trading technologies and market risks. Predictably, those who answered the questions were evenly divided on whether there was even a need for regulation.
At a May 2014 Congressional hearing, former CFTC Chief Economist, now MIT Professor, Andrei Kirilenko proposed that the CFTC create the new category of “automated brokers and traders.” They would be required to register with the CFTC and keep records and an audit trail which regulators and the exchanges could examine in the case of a flash crash or other market disruption. He also suggested that the exchanges be required to publish data on system latencies — that is, how long of a delay exists before market information reached participants — which would include the latency for messages for submitted, cancelled, modified and executed orders.3 That seems like a common sense starting point. No one appears to have followed up on Professor Kirilenko’s suggestion.
Bernard Baruch famously said, “The main purpose of the stock market is to make fools of as many men as possible.” (You can include women now.) Although there may be fewer high speed traders chasing diminishing profits, they still find ways to make many of us look foolish.
Even if high speed trading does have demonstrable benefits — providing liquidity of a sort and narrowing spreads — and even putting aside the instances of proven market manipulation, the results of using algorithms to make trades at lightning speed certainly make the process seem unfair.
What the exchanges, and the regulators, should be doing is to balance the benefits of high speed trading with rules that address the abuses and eliminate the perception that the markets simply do not provide investors with the level playing field to which everyone pays lip service. So far, they have come up short.
1 Shorter and Miller, High-Frequency Trading: Background, Concerns, and Regulatory Developments (Congressional Research Service June 19, 2014) (“Shorter and Miller”).
2 “Concept Release on Risk Controls and System Safeguards for Automated Trading Environments,” Commodity Futures Trading Commission, 78 Federal Register, No. 177 (Sept. 12, 2013).
3 Shorter and Miller, at 42-43.