Why New York AG wants curbs on high-frequency traders

March 19, 2014, 10:32 a.m. EDT
Why New York AG wants curbs on high-frequency traders
By Sital S. Patel
NEW YORK (MarketWatch) — High-frequency trading was thrust back into the spotlight when New York’s Attorney General Eric Schneiderman announced he would be taking a deeper look at the “unfair advantages” they have over regulator investors.
The New York regulator said U.S. exchanges allow traders to obtain pricing information fractions of a second earlier, through technology, giving them an edge.

“I have been focused on cracking down on fundamentally unfair — and potentially illegal — situations that give elite groups of traders early access to market-moving information at the expense of the rest of the market,” said Schneiderman in a speech at New York Law School on Tuesday. “We call it Insider Trading 2.0, and it is one of the greatest threats to public confidence in the markets.”
High-frequency trading is considered to be sophisticated computer trading algorithms that use trading strategies to move in and out of positions in fractions of a second, even milliseconds.
In the last several years, HFT volume has increased and has been considered a controversial practice, becoming the topic of many regulatory discussions. Trading algorithms were blamed in the “flash crash” in 2010 when the Dow Jones Industrial Average plunged about 1,000 points in just minutes, recovering quickly. However, proponents of HFT point to how it helps to improve market liquidity and reduces trading costs.
The New York Attorney General answered MarketWatch questions via email on why high-frequency trading was damaging to the markets. It’s been edited for length and clarity.
MarketWatch: What started this investigation into U.S. stock exchange activities related to data provided to high-frequency traders?
Schneiderman: I definitely am a believer in America’s capital markets, and I am a believer that our markets can only function with clear regulations, and uniform and equitable enforcement of those regulations. One of the fundamental principles that drives every part of my office is the very simple, very American notion of equal justice under law. There has to be one set of rules for everyone. That’s why we’ve been focusing on cracking down on fundamentally unfair situations that fall outside the parameters of traditional insider trading but give elite groups of traders access to market-moving information at the expense of other investors. We call it Insider Trading 2.0, and it’s one of the greatest threats to public confidence in the markets.
Last summer, for example, we learned that Thomson Reuters (NYSE:TRI) was letting high-frequency traders pay a premium for a two-second advantage in getting the survey of consumer confidence from the University of Michigan. With that two-second advantage, they were able to move the markets. To their credit, Thomson Reuters did the right thing once we confronted them about this and stopped selling that two-second edge. That is where our efforts began.
MarketWatch: Business Wire, the distributor of press releases owned by Warren Buffett’s Berkshire Hathaway Inc. (NYSE:BRK.B) , said last month it would stop sending the statements directly to high-frequency firms. Why is this issue so important to the average investor and who does this issue impact? How is this threatening the market?
Schneiderman: First of all, I applaud Business Wire’s decision to voluntarily step forward and stop selling its clients’ information directly to high-speed traders. They showed leadership, and I hope other companies will join them in the effort to level the playing field between high-frequency traders and the rest of the investing public.
Publicly traded companies are legally required to provide their key information to the investing world at the same time. Most companies contract with wire services like Business Wire to distribute their market-moving information, and most people get that information through news aggregators like Bloomberg and Dow Jones. We learned that some services were selling subscriptions directly to high-frequency traders, who were seeing the information a split second earlier than investors relying on services like Bloomberg and Dow Jones. That was enough for them to move the markets. So, again, I applaud Business Wire for bringing this to an end.
MarketWatch: This is a practice that has been openly permitted for years. What has been the response from the Securities and Exchange Commission on your probe? What other regulators are involved in the investigation?
Schneiderman: Actually, to their credit, the SEC and the [Commodity Futures Trading Commission] have raised questions in this area. SEC Chairman Mary Jo White has tried to work out a system of circuit-breakers to prevent massive fluctuations from damaging the market. But there is a lot more work to do. Part of the challenge is high-frequency trading did not even really exist 10 years ago, but in some respects it’s coming to dominate our markets. And, unfortunately, our markets and market institutions have started to cater to these traders. I look forward to joining with other regulators, with my colleagues in government, to take real, concrete steps to deal with this problem.
MarketWatch: These special services provided to high-speed traders involved computer programs executing orders in fraction of seconds. And it represented more than half of all U.S. stock trading in 2012, according to some reports. What do you propose as the change here?
Schneiderman: First of all, [Tuesday] I called on other regulators, my colleagues in government, to join us in taking real, concrete steps to deal with this problem. More specifically, I think we need to strongly consider proposals like the ones put forward by economists at the University of Chicago School of Business — not exactly an enemy of free markets — that would fundamentally reorient the markets in a very simple way. Their proposals would reaffirm the basic concept that the best price — not the highest speed — should win.
Currently, on our exchanges, securities are traded continuously, which means that orders are constantly accepted and matched with ties broken based on which orders arrived first. This system rewards high-frequency traders who continuously flood the market with orders – emphasizing speed over price. The University of Chicago proposal — which I endorse — would, in effect, put a speed bump in place. Orders would be processed in batches after short intervals — potentially a second or less than a second in length – but that would ensure that the price would be the deciding factor in who obtains a trade, not who has the fastest supercomputer and early access to market-moving information. This structural reform — sometimes called “frequent batch auctions” — would help catch and cap the supercomputer arms race now underway. This is tremendously important, because even advocates of high-frequency trading have always recognized that the potential for destabilization of the markets from volatility is a problem.
MarketWatch: What has been the response of the biggest exchanges, including NYSE, Nasdaq and BATS Global Markets?
Schneiderman: So far, in each of our efforts to curb what we call Insider Trading 2.0, we have been fortunate to have industry leaders that voluntarily agree to stop doing what they’re doing. Thomson Reuters agreed to stop giving a two second advantage to a small sliver of their customers. Business Wire agreed to stop selling directly to high-frequency traders. BlackRock agreed to end its analyst survey programs, and 18 of the largest analysts agreed to stop participating in those surveys. My hope is that the exchanges will respond in a similar way and seriously consider structural reforms that would reign in the unfair advantages available to high-frequency traders.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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