NY takes aim at high frequency traders

The opaque world of high frequency trading is coming under increasing scrutiny from regulators as the New York Attorney General Eric Schneiderman said he was looking into practices in the space.

Andrew R. Johnson had this story for the Wall Street Journal:

New York Attorney General Eric Schneiderman is investigating services offered by stock exchanges that he alleges give certain high-speed investors an unfair advantage by getting early access to data.

Mr. Schneiderman said during a speech Tuesday that he was urging stock exchanges to consider curbing such features and adopting proposed safeguards to ensure investors are competing on an equal playing field.

The features in question include “co-location,” which allow traders to locate their computer servers within exchanges’ data centers, and services that provide extra network bandwidth to high-frequency traders.

“These valuable advantages give high-frequency traders a leg up on the rest of the market,” Mr. Schneiderman said in the speech at New York Law School.

Mr. Schneiderman’s proposal is the latest in a continuing probe of Wall Street activities that allow investors and other market participants to gain a competitive edge through the early release of market-moving data, a practice he calls “insider trading 2.0.

Bloomberg reported that stock exchanges have been alerted to the attorney general’s concerns in a story by Keri Geiger and Sam Mamudi:

The attorney general’s staff has discussed his concerns with executives of Nasdaq and NYSE and requested more information, according to a person familiar with the matter, who asked not to be named because the talks were private. Schneiderman’s office is also looking into private trading venues, known as dark pools, and the strategies deployed by the high-speed traders themselves.

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The investigation threatens to disrupt a model that market regulators have openly 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 centers as the exchanges, a practice known as co-location that lets them directly plug in their companies’ servers and shave millionths of a second off transactions. They also purchase proprietary data feeds, which are faster and more detailed than the stock-trading information available on the public ticker.

“We publicly file with the SEC for each and every one of these services, and we’re always engaged with government officials around the world,” Robert Madden, a spokesman for New York-based Nasdaq, said in a phone interview, referring to the U.S. Securities and Exchange Commission. He and Eric Ryan, a spokesman for NYSE, declined to comment on Schneiderman’s investigation.

Writing for the Financial Times, Kara Scannell and Arash Massoudi pointed out that the Securities and Exchange Commission brought enforcement actions against some trading platforms regarding this issue:

Mary Jo White, chairman of the Securities and Exchange Commission, the federal agency that regulates the equity markets, told a congressional panel last year that high-speed markets required “constant monitoring and analysis.”

Over the past few years the SEC has brought enforcement actions against NYSE and other trading platforms for giving certain investors better access to the markets.

An SEC spokesman said: “We are working on these and a wide range of issues as part of our ongoing review of our current equity market structure. We appreciate hearing the views of all market participants and other interested parties, including attorney-general Schneiderman.”

The investigation comes as Virtu Financial, a leading global proprietary trading company, is preparing to launch investor meetings for an initial public offering later this quarter, which would make it the first pure HFT company to go public.

People familiar with Virtu’s plans have said it hopes to raise $250m from a listing at a valuation of as much as $3bn.

The attorney-general’s office has made a priority of looking at potential insider trading by firms that are quick enough or rich enough to gain an early look at market moving information. While it is not Wall Street’s top regulator, the office has often wielded the Martin Act to force change in lieu of filing lawsuits.

In an interview on CNBC today, detailed in a story by Bruno J. Navarro, Scheinderman said he wasn’t opposed to capital markets, just those who have an unfair advantage:

“The problem is high-frequency trading—it creates liquidity; that’s a good thing—but it creates instability, and that’s a bad thing,” he said. “And the constant arms race of people having the incentive, which they have now, to try untested methods to gain those extra milliseconds of speed—that is a danger to the markets.”

Scheinderman suggested that frequent batch auctions might be one solution.

The practice would help maintain liquidity in the markets while removing the ability for traders to exploit momentary mispricings with increasingly faster computers.

“They’re using arbitrage between exchanges now,” he said. “Tiny, tiny differences in the timing of pricing can now make money for these folks. So, what my proposal was, as regulators—the federal government’s got to be involved in this, too, CFTC and SEC—we’ve got to step up to the plate and deal with the challenges of this new technology.”

Schneiderman said he wasn’t thinking about proposing a tax on certain kinds of trading.

“I’m a big fan of America’s capital markets,” he said. “In the last five years, we have funded something like five times all of Europe has funded in terms of investments and start-up companies and almost five times the rest of the world,” he said.

“Right now, because of this constant quest for those extra milliseconds, the markets are at a little bit more risk than they need to be. We can preserve the liquidity by something like our frequent batch auction proposal, which is being discussed at a forum at New York Law School right now, while protecting the markets and capping the race for speed.”

While milliseconds might not seem like a lot, it can mean millions for high-frequency traders. Schneiderman said that quest for timing created extra risk in the system than necessary, but that’s a claim that could be hard to prove. Hopefully he’ll publicly disclose the findings of his investigation in the spirit of transparency that he’s promoting.