Is High-Frequency Trading Insider Trading?by
Ever since Michael Lewis went on 60 Minutes Sunday night to accuse high-frequency traders of rigging the stock market, it has been hard to avoid the debate over HFT’s merits and evils. Some of it’s been useful; most has been a lot of angry yelling. The peak of the frenzy came on Tuesday afternoon in a heated segment on CNBC with IEX’s Brad Katsuyama and BATS Chief Executive Officer William O’Brien.
To me, this debate is just circling the ultimate question: Should high-frequency trading be considered insider trading?
Classically defined, insider trading means having access to material, non-public information before it reaches the rest of the market; it’s like getting a heads-up about a merger before it’s announced, or maybe a phone call from a Goldman Sachs board member saying that Warren Buffett is about to invest $5 billion in the bank. Over the past few years, federal prosecutors have collected a number of big insider-trading convictions of people who got early word about a piece of highly valuable information and made a lot of money as a result.
To its most vehement critics, high-frequency trading is not terribly dissimilar. The most common accusation is that these traders get better information faster than the rest of the market. They do this through three primary methods:
First, they put computer servers next to those of the exchanges, cutting down the time it takes for an order to travel from their computers to the exchanges’ electronic matching engines. Second, they use faster pathways—fiber-optic cables, microwave towers, and yes, even laser beams—to trade more quickly between far-flung markets such as Chicago and New York.
Last, they pay exchanges for proprietary data feeds. This is where it gets really complicated. These proprietary feeds are different than the public, consolidated data feed maintained by the public exchanges, called the securities information processor, or the SIP. Though it’s now a piece of software, the public feed is the modern-day equivalent of the ticker tape that provided stock price data to brokers, traders, and media outlets. It’s what feeds the stock quotes crawling along the bottom of the screen on CNBC Bloomberg TV, or on financial websites; when the public feed broke in August, trading on NASDAQ stopped for 3 hours.
While the purpose of the public feed is to ensure that everyone gets the same price information at the same time, the playing field isn’t as level as it would seem since exchanges sell proprietary feeds. And not just to HFT firms. Lots of different types of investors buy proprietary market data from exchanges. By law, prices must be entered into the SIP and the proprietary feeds at the same time, but once the data leaves the exchanges, the proprietary systems often process and transmit the information faster. These feeds arrive sooner and contain more robust information—including all prices being offered, not just the best ones.
From 2006 to 2012, Nasdaq’s proprietary market data revenue more than doubled, to $150 million. The money it earns from the public feed fell 21 percent over roughly the same period. So while Nasdaq used to earn more money from its public feed, it now makes more from proprietary ones. Especially after the August outage, this has stirred a lot of complaints from market players that the SIP has been neglected in favor of prop feeds. For its part, Nasdaq has been lobbying the committee that oversees the SIP to beef it up.
Speed traders spend a lot of money for faster access to better information. This allows them to react more quickly to news and, in some cases, jump in front of other people’s orders by figuring out which way the market is going to move. So is that insider trading?
New York Attorney General Eric Schneiderman has called HFT “insider trading 2.0″ on a number of occasions. His office is looking into the relationships between traders, brokers and exchanges and asking whether it all needs to be reformed. The FBI spent the last year looking to uncover manipulative trading practices among HFT firms; the federal agency is now asking speed traders to come forward as whistleblowers.
U.S. laws dealing with insider trading were first passed 80 years ago. Some restrict the way corporate executives and board members can trade in and out of their company’s shares. Others deal with the fair disclosure of important information—which, when it comes to high-frequency trading, is what we’re talking about here. These laws essentially require companies to release material information, such as earnings, to everyone at the same time. No playing favorites.
But technology is starting to stretch the usefulness of this narrow definition, and it’s not just HFT. Last year, the Securities and Exchange Commission said companies can use social media sites such as Twitter and Facebook to release material information so long as investors are told which outlets will be used. This is one reason why some speed traders have started mainlining Twitter’s raw data feed into their trading engines.
They pay for that feed, just as they pay for other technological advantages. So what happens when some traders are able to hear information quicker than others, not through nefarious means but by dint of their technology? There are plenty of examples in history where early adopters used technologies—the telegraph, say, or the telephone—to get information quicker than everyone else, and then profited from it. As a defender of high-frequency trading put it to me: The high-speed, algorithmic trading computer is the new carrier pigeon.
The truth is neither as simple nor as benign as that, but is there a point at which a technological edge becomes an illegal informational one? You can make the case that in some ways, the advantages HFT firms pay for are similar to the controversy over “expert-networks,” which hedge funds pay to access industry experts in certain fields; sometimes the “knowledge” they are able to glean borders on ill-gotten inside information.
What seems obvious is that HFT is forcing us to debate the current state of the market, which is completely different than it was 80 years ago, when the first insider trading laws were written. People on both sides of this debate agree that the market has become overly complex and rife with perverse incentives that don’t necessarily benefit the broader public. Perhaps, as Schneiderman and the FBI reinvigorate their investigations into speed trading, regulators and lawmakers will be inspired to update our definition of insider trading to account for the rapidly blurring line between the information investors have and the ways they get it.