By Stephen Anson
Equipped with some of the most powerful super-computers in the world, high-frequency traders anticipate millisecond changes in the market, allowing them to score immediate gains and affect the market index. These trading practices have been used for years, and though there are many federal rules criminalizing insider trading and securities fraud, no one has used these rules to go after high-frequency traders until recently. Whether or not these trades are illegal remains an open question. In the interim, growing public discontent will likely lead to more lawsuits and perhaps eventual securities reform.
Public interest in high-frequency trading has grown lately, spurred in part by Michael Lewis’s new book “Flash Boys.” In his book, Lewis described the market as being “rigged” by “high-frequency traders armed with fiber-optic lines and computer servers located next to, or even inside, the exchanges.” This advanced technology gives high-frequency traders an advantage over other traders. The technology provides faster access to information about the flow of the market, and the traders then use advanced algorithms to purchase as many of the “in demand” securities as possible. Their computer programs will then, nearly instantaneously, sell those same securities back out in the market, often for a nice little margin. High-frequency traders can still turn a profit, even if they are buying large volumes of stock and selling them for the same price, because they receive a liquidity rebate for each transaction from the relevant exchange. The exchanges, such as the New York Stock Exchange (“NYSE”), pay these liquidity rebates, which typically amount to a fraction of a penny per share, because it increases the overall liquidity in that marketplace.
Four years ago, on May 6, 2010, a “flash crash” wiped out $1 trillion in wealth in the blink of an eye when the Dow Jones Industrial Average dove roughly 1,000 points, only to rebound within minutes. Although investors and academics still cannot agree on what caused this devastating short circuiting of markets, high frequency computerized trading is believed to have contributed. When trades are completed in milliseconds, the market can rapidly fall down the proverbial rabbit hole.
Amidst growing public awareness about high-frequency trading, New York Attorney General Eric Schneiderman recently sent subpoenas to the high-speed trading firms. Schneiderman is investigating whether the firms have secret arrangements with stock exchanges or other trading venues, or anything else which would give the firms the ability to trade ahead of other investors. He is expected to send subpoenas to the exchanges in the near future to gather more information for his investigation.
In City of Providence, Rhode Island v. Bats Global Markets Inc., the city of Providence has sued Bank of America, NYSE and dozens of other brokerages and traders, claiming they rigged the securities market and diverted billions of dollars from public investors that bought or sold stock in the last five years. The FBI has also shown an interest in high-frequency traders, and is looking into how much of an improper jump on other investors high-speed traders get by using information about their trading to make profits.
Prosecuting high-frequency traders under existing securities law presents a challenge. Insider trading requires a misuse of confidential information that constitutes a breach of a fiduciary duty. In contrast to conventional insider trading, high-frequency traders pay the stock exchanges for the information, so there is no clear misuse of confidential information because high-frequency traders use legitimately purchased information. It may also be difficult to prove intent to defraud when the traders have minimal interests in the underlying values of the company and an algorithm makes the investment decision within a fraction of a second.
It is also unclear that the harms of high-frequency trading actually outweigh the benefits of increased liquidity and narrower spreads between the bid and ask prices. Some argue that more data should be collected before the SEC moves to regulate this practice more strictly. Others view speed trading as clearly illegal insider trading. Regardless of the outcome, high-frequency trading illustrates how the SEC must evolve as technology advances in the financial realm.