SEC probes high-speed traders, report says

Federal investigation into potential for unfair advantages was prompted by 2010 'flash crash'

The U.S. Securities and Exchange Commission (SEC) is investigating whether trading firms that use computerized high-frequency trading algorithms have an unfair advantage over other investors, according to a published report.

Citing unnamed sources, The Wall Street Journal (WSJ) reported that the probe was prompted by the SEC's investigation into the so called "flash crash" in 2010.

The SEC did not immediately return a request for information on the latest investigation.

According to the Journal, the SEC is focusing the current investigation on a number of computerized exchanges, including BATS Global Markets, which operates stock exchanges in the U.S., the BZX Exchange and the BYX Exchange. BATS, based in Lenexa, Kan., is in the process of going public.

The probe is looking into communications between some high-frequency trading firms and computer-driven exchanges, such as Direct Edge Holdings LLC, according to WSJ's report.

David Schehr, Gartner's research director in the Banking and Investment Services, said that while high-frequency trading firms may have an advantage over retail traders, there is nothing as yet to indicate that they're doing anything wrong.

That institutional traders, such as mutual fund managers, often operate systems close to a stock exchange's servers in order speed data transfers is not necessarily unfair, Schehr said.

"Physics is physics. Nobody's doing anything wrong. If people want to pay to be 20 feet from an exchange server rather than 200 miles, that effects things," he said.

Schehr also pointed out that retail traders have an advantage in that they don't have to participate in the markets, where institutional traders must buy and sell based on what investors want, making their trading activity more suseptable to market volatility.

"We're talking nuclear bomb versus cap gun, but you don't have to go to the fight [if you're a retail trader]," he said.

The so-called flash crash, which took place in October, 2010, saw the Dow plunge by almost 1,000 points in half an hour, wreaking havoc on the financial markets.

Investigators blamed an automated trade execution system for that crash. Specifically, an automated trade execution system had flooded the Chicago Mercantile Exchange's Globex electronic trading platform with a large sell order causing a panic among investors.

As a result of the flash crash, the Financial Industry Regulatory Authority (FINRA), the enforcement arm of the SEC, began examining less-transparent parts of the securities markets, such as the fast-growing area of so-called high-frequency trading.

FINRA responded to the flash crash by enacting rules requiring a pause in the trading of individual stocks when the price moves 10% or more either way in a five-minute period.

FINRA's most recent investigation, according to the WSJ report, will look at whether high-speed trading firms gain an unfair advantage because they can complete sub-second stock trades.

Sub-second trades, which are enabled by high-frequency trading algorithms on powerful computers, react to even small adjustments in the market, executing trades based on stocks moving fractions of pennies.

"If high-frequency traders are fighting back and forth, it's happening at a level that's almost noise to more traditional traders," Schehr said.

"If there's a group of people out there all fighting to shave a millisecond here and shave a millisecond there ... it's like looking at things at the molecular versus the atomic versus the sub-atomic level. What goes on at one level compared to a level below becomes noise," he added.

Lucas Mearian covers storage, disaster recovery and business continuity, financial services infrastructure and health care IT for Computerworld. Follow Lucas on Twitter at @lucasmearian, or subscribe to Lucas's RSS feed . His e-mail address is lmearian@computerworld.com.

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