It’s been almost two years since the “Flash Crash” of May 2010, when the Dow Jones plummeted 600 points in five minutes, only to gain most of it back over the next 20. In their after-action report (pdf) a few months later, the SEC and CFTC faulted high-frequency traders for exaggerating the sell-off with their rapid-fire trading techniques.
Since then, regulators have spoken repeatedly about their intent to crack down on speed traders, a breed of computer jockeys who use sophisticated algorithms to trade stocks and other assets in as little as 1-millionth of a second. But with the exception of some small rule changes, nothing has really changed. High-frequency trading remains today as it was two years ago: an opaque, misunderstood, and almost totally unregulated industry worth billions of dollars. Since a lot of high-frequency trading firms are small shops trading for themselves, rather than banks or brokers, they fall into a regulatory black hole that financial watchdogs have struggled to fill.
The latest regulatory tough talk came last week during a futures-industry conference in Boca Raton, Fla., where two prominent regulators, CFTC Chairman Gary Gensler and the ever-colorful commissioner, Bart Chilton, both talked about the need to keep a closer eye on high-frequency traders. Chilton, the most outspoken regulator on the need to rein in speed trading, admitted in a speech that while he’s fascinated by high-frequency traders (whom he refers to as “cheetahs”), regulators “haven’t done enough” and that “to assume that all technology is good without question is naive as a general matter and dangerous for a regulator.” Five days earlier in New York, Chilton told reporters that speed traders should have to register so regulators can actually know who they are.
Gensler gave a more conventional keynote speech at the Futures Industry Association conference in Boca, which in a way was like being in the lion’s den (or the cheetah’s den), since a division of the FIA represents firms that trade their own capital, many of which are very active users of high-frequency trading. Although his speech included only a passing reference to high-frequency trading, Gensler later told the Wall Street Journal that he intends to ramp up efforts to monitor speed traders in the futures markets, tracking not just trades that get executed, but also the countless buy and sell orders that get canceled almost as soon as they’re made.
A chief criticism of high-frequency traders is that they manipulate markets by spamming exchanges with millions of fake buy and sell orders that never get executed. The theory is that they can trick large institutional investors by distorting their perception of how much real demand exists for a particular trade. While defenders of speed traders argue this saturation of buy and sell orders adds price information and liquidity to markets, critics say it’s a deceptive strategy that also allows speed traders to detect the trading intentions of larger, less nimble firms and get ahead of them by driving the price up or down. According to Gensler’s WSJ interview, 80 to 90 futures orders are offered for every one that actually gets filled. Several exchanges have recently announced intentions to limit the number of cancelled orders a firm can place for every one it fills. But critics remain skeptical whether that will really cut down on the practice.
“It sounds like [regulators] suspect manipulation is going on, but that they can’t prove it,” says Joe Saluzzi, a vocal critic of high-frequency trading and co-founder of Themis Trading, a New Jersey firm that trades on behalf of large institutional clients. “If they think there’s a crime going on but don’t have the ability to gather the evidence to prove it, that’s scary.”
The problem for regulators is twofold: They lack not only the expertise but also the technology to police speed traders adequately. Last month, after her agency had spent more than a year studying the complexities of high-frequency trading, SEC Chairwoman Mary Schapiro admitted that regulators still don’t understand the industry enough to police it sufficiently. Even if they did, they don’t have the advanced computer systems to keep up. It’s as if the regulators are on horseback while the traders are in Ferraris. “To say they’re outmatched would be an understatement,” says Saluzzi.
Gensler told the WSJ that the CFTC is building its own sophisticated computer system to track orders, including those that don’t get filled. In 2010, the SEC proposed building its own tracking system called the Consolidated Audit Trail (CAT). Good idea, except people balked at its $4 billion price tag.
“It’s frustrating,” says Saluzzi. “It’s been a few years of knowing there was a problem, and they really haven’t done anything to figure this out. Nothing is going to change until they have the proper tools to police the system.”
That of course costs money. And as long as shrinking government is the order of the day among Congressional Republicans, regulators are going to have a hard time getting the resources needed to keep up with speed traders. Last fall, Gensler had to fight efforts to slash his agency’s budget. Though it has grown over the past few years, the CFTC has only 700 employees. The SEC has about 3,500 employees.
Although this lack of understanding among regulators has so far shielded speed traders from tighter rules, many worry that it’ll eventually lead to regulatory overstep. There’s a perception among many traders that regulators are washed up traders and lawyers who’ve been left behind by the rapid advancements electronic trading has made over the past decade. “Finance has changed from a gambling culture to an engineering culture, and the regulation needs to evolve with it,” says Ben Van Vliet, a professor at Illinois Institute of Technology.
Along with fake order flow, the other big complaint about speed traders is that they prey on large institutional investors. A big pension fund trying to buy 100,000 shares of IBM, for example, must devise ways to cloak its activity; otherwise, high-frequency algorithms can swarm the trade with buy and sell orders. By trading in front of large orders, speed traders can move prices to their advantage, driving up the cost of doing business for less sophisticated trading operations.
Firms such as Saluzzi’s Themis Trading help large firms navigate this world and try to execute big trades without getting noticed. “You have to dance around them. It requires constant work,” says Saluzzi. “The problem with the market right now is that lots of guys have older algorithms that leave footprints and cookie crumbs. If you’re dumb enough to leave your order out there and be unsophisticated, there’s nothing that more regulation is going to help you with.”
Next week, CFTC Commissioner Scott O’Malia will convene an advisory panel on high-frequency trading, which will include a number of speed traders. “A lot of our members are eager to be part of this panel and have a good discussion,” says Will Acworth, who runs media relations for the FIA. O’Malia has indicated that he’s not necessarily interested in reining in speed traders but merely wants to learn more about them.
Obviously, regulators should take their time studying an industry before trying to regulate it. But in a world that measures time in microseconds, does it have to take so long?