Scrutiny of high-frequency trading is stirring memories among investment veterans of earlier scandals when the government targeted price-fixing and fraud in U.S. equity markets.
Michael Lewis’s book “Flash Boys” and probes by the New York attorney general and Federal Bureau of Investigation are spurring outcry from Washington to Newport Beach, California, as investors and politicians ask if exchanges are rigged. Shares of Nasdaq OMX Group Inc. and IntercontinentalExchange Group Inc. have lost at least 8.8 percent in 2014 after each posted their best annual gains since 2007 and 2006, respectively.
The pitch rose at the end of last week as Pacific Investment Management Co.’s Bill Gross warned on Bloomberg Radio with Tom Keene that speed traders give the equity market a “negative cast” and investor Mario Gabelli said in a separate interview on Bloomberg Television that it rips off consumers. All the attention reminded 70-year-old hedge fund manager Buzzy Geduld of an earlier era, when allegations of misconduct by Nasdaq traders and New York Stock Exchange floor specialists shook public confidence.
“Now you’ve got it in the 2000s, with these guys who probably for the past 10 or 15 years have been developing these systems, and the real problem is the regulators are always trying to catch up,” Geduld, who sold his firm Herzog Heine Geduld Inc. to Merrill Lynch & Co. in 2000 for more than $900 million and now runs Cougar Capital LLC in New York, said in an April 4 phone interview. “Sometimes what it takes to get a regulator off their backside to actually look at something and say, ‘We’ve got to fix this,’ is public outcry.”
Robert Madden, a spokesman for Nasdaq OMX, and Eric Ryan of IntercontinentalExchange’s NYSE, declined to comment on parallels between HFT and earlier investigations.
Debate has raged for a week since Lewis, a columnist for Bloomberg View, told “60 Minutes” that the stock market is rigged and allows speed traders to front-run orders by mutual funds, pensions and individuals. Though his points drew rebuttals from executives such as Bill O’Brien, president of exchange operator Bats Global Markets Inc., it is striking a chord in public, where individual investors have just started returning to equities five years after the financial crisis.
U.S. Attorney General Eric Holder has promised a thorough investigation into whether HFT violates insider trading laws.
“The department is committed to ensuring the integrity of our financial markets, and we are determined to follow this investigation wherever the facts and the law may lead,” Holder said April 4 at a hearing of the House Appropriations subcommittee that oversees the Justice Department.
The FBI is also looking into trading practices and is soliciting tips on possible front-running. New York Attorney General Eric Schneiderman said in March that he opened an investigation into whether exchanges provide high-frequency traders with improper advantages.
“High-frequency trading as applied to the stock market has a negative cast,” Gross said in an interview on Bloomberg Radio with Tom Keene. “Michael Lewis has an argument.”
Gabelli, the founder of Rye, New York-based Gamco Investors Inc., said speed trading exploits consumers.
“If you go in and watch the stock and how they probe at $60.22 a bid for 400 shares, before you can put in an order to sell it, the bid disappears,” Gabelli said. “They should hold it firm for a period of time.”
To John Carey, a fund manager at Pioneer Investment Management Inc. in Boston, there’s always been a price to pay for accessing the equity market.
“My assumption from the moment I entered the industry, and it’s 35 years now that I’ve worked in the stock market, was that someone was going to be profiting from the trading that I did,” said Carey, whose firm manages about $220 billion worldwide. “In the interests of being able to participate in the market, I’m willing to give up something.”
Government investigations in the 1990s and 2000s dislodged practices that bear resemblances to the ones Lewis says are rampant now, laying the foundation for today’s electronic markets. Proponents of high-frequency trading say strategies relying on computers to buy and sell stock at speeds measured in millionths of a second make markets more transparent.
“Our fragmented equity-execution framework is the definition of a competitive market, where competition has made trading much less expensive, faster and more open,” Larry Tabb, founder of market-research firm Tabb Group LLC, wrote last week. “Average effective spreads are down and investors are much more in control of their execution than ever before.”
Spreads, or the difference between prices to buy and sell a stock, have been part of debates about market integrity for decades. Advocates for HFT say its ability to reduce that gap lowers costs to investors and shows how much better markets are today compared with the past.
Following investigations by the U.S. government, a federal judge in 1998 approved a $1.03 billion settlement that 37 brokerages reached with investors who accused the firms of overcharging for prices on the Nasdaq Stock Market. Firms such as Merrill Lynch and Goldman Sachs Group Inc. kept spreads artificially wide to boost market-making profits, according to the lawsuit. According to a document on the website of the Federal Reserve Bank of Atlanta, the agreement was thought to be the largest civil antitrust settlement in U.S. history.
The settlement was reached several years after the publication of a research paper by William G. Christie and Paul H. Schultz titled “Why do Nasdaq Market Makers Avoid Odd-Eighths Quotes?” In it, the finance professors from Vanderbilt University and Ohio State University said orders for 70 of the 100 most-traded companies on the Nasdaq Stock Market were almost always quoted in “even eights” -- in other words, two-eights or four-eights of a dollar, and rarely one-eighth -- ensuring a 25-cent spread for dealers to profit from.
In 2004, seven NYSE market makers agreed to pay the Securities and Exchange Commission $247 million to settle allegations that they made unnecessary trades that cost clients.
The U.S. government’s pursuit of criminal charges against 15 individual specialists for securities fraud went nowhere. Some were acquitted while others saw their charges dismissed. One jury conviction of a Fleet Specialist Inc. employee was overturned by a federal judge, who said prosecutors hadn’t proved fraud. The guilty pleas of two others were set aside.
It’s unlikely that the latest investigations will lead to arrests, said Joe Saluzzi, co-head of equity trading at Themis Trading LLC.
“Technically, as far as we can tell, there are no rules being broken,” he said in an April 4 phone call. “The situation then becomes, ‘Maybe the rules need to be tweaked a little,’ and that’s probably more what you’ll see.”
Saluzzi said the current controversy hasn’t just popped up. “This has been building for years and years,” he said, which is what makes it different from the Christie and Schultz paper that exposed the “even eighths” quote scandal.
Today’s market structure has its roots in those earlier issues. At the SEC’s behest, Nasdaq adopted order-handling rules in 1997 requiring that limit orders be shown to the public when they were superior to quotes posted by market makers, according to a 2001 paper in the Journal of Financial Markets. The minimum size of quotes fell to 100 shares from 1,000.
Those and other changes helped popularize alternative venues known as electronic communications networks. Two of the biggest, Island ECN and Archipelago Holdings Inc., were later bought by Nasdaq and NYSE and still serve as part of the infrastructure of their exchanges.
Thomas Caldwell, a 49-year investment industry veteran who is the chief executive officer of Caldwell Securities Ltd., said high-frequency trading is sharpening attention like nothing since the Bernard Madoff ponzi scheme was uncovered.
“It certainly focused people on the market who heretofore hadn’t been,” Caldwell said in a phone interview from Toronto on April 4. “Tomorrow morning I’m down in Florida. I’m going to get the book and just read it.”