SEC Leads From Behind as High-Frequency Trading Shows Data Gap
The U.S. Securities and Exchange Commission, stung by criticism that it lacks the knowledge to analyze the computerized trading that has come to dominate American stock markets, is planning to catch up.
Initiatives to increase the breadth of data received from exchanges and to record orders from origination to execution are at the center of the effort. Gregg Berman, who holds a doctorate in physics from Princeton University, will head the commission’s planned office of analytics and research.
“What we will focus on is trying to shed more light on some of the big outstanding questions about market structure,” Berman said in an interview in Washington. “What is the impact of high-frequency trading? What’s the effect of high rates of order cancellations? What’s the connection between exchange- traded funds and individual stocks? How might different rules impact the market?”
Berman’s team will assess how market behavior has been altered after 15 years of regulatory reform and advances in technology that have left trading fragmented across 13 competing exchanges, 10 options markets and dozens of venues operated privately by brokerages. SEC Chairman Mary Schapiro, spurred into action by the stock rout of May 6, 2010, has made improving data collection a priority.
High-frequency strategies, which process massive amounts of quote and transaction data and rely on the rapid-fire submission of orders to exchanges, account for 51 percent of U.S. equity volume, up from 35 percent in 2007, according to research firm Tabb Group LLC. They include electronic market making, statistical arbitrage and tactics based on price movements in indexes compared with their constituent stocks.
Critics say the commission isn’t moving fast enough to rein in the quickest traders and that money-raising functions such as initial public offerings are being harmed by perceptions the market is geared toward speculators. Initiatives similar to the so-called consolidated audit trail, meant to enhance order tracking, have been around since the early 1980s, said David Weild, the New York-based head of capital markets with Grant Thornton LLP.
“It’s amazing it’s taken 30 years,” Weild, a former vice chairman of Nasdaq Stock Market, said in a phone interview. “Meanwhile, there’s been an arms race on Wall Street and the SEC is outclassed in its ability to reconstruct events and look for vulnerabilities.”
Concern for the stability of U.S. markets has increased following the so-called flash crash of May 2010, the botched initial public offering of Facebook Inc. (FB) in May and Knight Capital Group Inc. (KCG)’s $440 million trading loss in August. The SEC has scheduled a meeting today in Washington for industry professionals and academics to discuss ways to limit technology breakdowns.
The proliferation of venues, faster trading speeds and the use of increasingly complex orders warrant a coordinated review of regulations that made the market more complicated and helped high-frequency trading flourish, Joseph Mecane, head of U.S. equities at NYSE Euronext (NYX), said at a conference in Washington last month. The analysis should focus on Regulation NMS, the set of rules implemented in 2007 to foster competition among exchanges and drive costs down for investors, he said.
According to Berman, the key to understanding what’s going on and whether rule changes are warranted is first figuring out the right questions to ask and what the data can reveal. Regulators can’t answer everything, he said.
“The art of quantitative analysis is knowing what you’re supposed to plot on the X axis versus the Y axis so it actually reveals something interesting and actionable,” he said. “It’s about knowing when the result tells you something real and when it’s just an artifact of the data. Sometimes quantitative analysis requires serious math and writing computer programs that go through a complex algorithm, but not always.”
The SEC has two initiatives to make his job easier. Schapiro proposed a mechanism for tracking all order and trading information known as the consolidated audit trail within weeks of the 2010 crash, which briefly erased $862 billion from U.S. share values. The system will trace customer data and the way orders are passed between brokers and private dark pools before they’re completed or canceled, information that has never before been compiled.
It also acquired a research tool from high-frequency firm and technology vendor Tradeworx Inc. What the SEC calls its market information data analytics system, or Midas, will collect trading data that exchanges provide to the high-speed firms and brokers that want information milliseconds before the public. The feeds also include data not available elsewhere.
The audit trail won’t be in place for several years and the industry hasn’t figured out how much it will cost and who will pay for it. Midas will be fully rolled out by the end of 2012, Berman said. It won’t include information about the one-third of trading that occurs away from exchanges.
“We’re starting with the equities market because there’s a system we can implement quickly,” Berman said. His group may also be able to conduct data-driven research into how other markets function, such as equity options, corporate bonds and exchange-traded products. Still, he said, the research starts with formulating the right questions. “We unfortunately don’t have a HAL 9000 or Star Trek-type computer where you simply throw data at it and it spits out the answer,” he said.
Data will be gathered to analyze market crashes and other events, discern trends related to how liquidity is provided and how often order cancellations occur, and monitor markets, according to Berman. If automated checks spot an anomaly, analysts can probe the data to decide if further investigation is warranted, he said. The SEC can also use data to inform rulemaking and policies, he said.
In response to asset managers who say that existing orders disappear when they try to buy or sell shares, the SEC can look at instances with individual stocks to see if that happens and how long it takes to “eat through the available liquidity,” said Berman, who is a special adviser to the director of the SEC’s division of trading and markets. The office of analytics and research will be housed within that division.
Some automated strategies may cancel more than 90 percent of the orders they send to exchanges, the SEC said in a 2010 report. Critics such as investment manager T. Rowe Price Group Inc. and broker Themis Trading LLC say the traffic rates and potentially abusive behavior mitigate benefits of high-frequency trading, such as tighter spreads between the best bids and offers.
‘How Markets Work’
“We can actually provide some metrics around some of the anecdotes from institutions that say the volume is fleeting, that it’s there and then it’s not,” Berman said. “Are there patterns between cancels and the size of a stock? How do cancels affect large versus small-cap stocks, or ETFs? This analysis can help us generate more information about how markets work.”
Berman, who studied experimental and nuclear physics, developed trading strategies in commodities and stocks at a hedge fund and became a founding member of RiskMetrics Group Inc. in 1998 when JPMorgan Chase & Co. spun off the company. He writes programming code and did some of the flash-crash modeling when the SEC examined how trade requests were withdrawn from exchange order books that day.
The analytics and research office plans to hire traders from banks and hedge funds as well as financial engineers and individuals with quantitative and analytical skills. It’s looking for programmers in the C++ computer language and “UNIX gurus who really know how to get under the hood and in former lives may have written trading programs and now are going to write analytical programs,” Berman said.
Berman’s group will devise monitoring programs and look for patterns and outliers that might indicate nefarious behavior or market manipulation. It will also study message traffic to spot delays between the proprietary data feeds and the public streams, Berman said. The SEC fined the New York Stock Exchange $5 million last month for sending information to its private feeds faster than it provided the data to the public.
Those drawn to Wall Street because they want to analyze risk will also be welcome, he said.
“Some people thrive on the pressure,” Berman said. “If they can’t lose their shirt in a day, they don’t feel like they’ve lived. But there’s a certain percentage who say ’I have to tolerate that and bear it because I’m interested in analyzing the risk.’ Those are the people that we’re looking for -- people who want to understand the markets without having to commit to the life of someone who trades on Wall Street.”
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