Is This High-Frequency Trade Probe Spooking the Market?

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Calling high-frequency trading (HFT) “one of the greatest threats to public confidence in the market,” New York Attorney General Eric Schneiderman announced Tuesday that his office is widening the scope of its investigation into HFT firms. Schneiderman is investigating the possibility that these firms provide their clients with market-specific data and speed advantages detrimental to the general trading public to include industries servicing these trading firms.

These remarks signal Schneiderman’s latest attempt to curb the practice that he refers to as “insider trading 2.0.” His first success in the inquiry materialized last July when Thomson Reuters agreed to stop providing select clients with early access to market-affecting consumer survey results.

In January, New York settled with BlackRock, which ended its analyst survey program that previously allowed the investment firm to gather information that could benefit its clients ahead of the public. Late last month, Schneiderman’s office reached a similar agreement with sixteen top investment firms, including JPMorgan Chase (NYSE:JPM) and Goldman Sachs (NYSE:GS), to halt a similar process. In a MarketWatch interview, Schneiderman applauded the recent decision by Berkshire Hathaway (NYSE:BRKA)(NYSE:BRKB), the press release distributor owned by Warren Buffett, to voluntarily suspend its practice of the same.

High-frequency trading, which mainly deals in securities, was born in the late 1990s, when the U.S. Securities and Exchange Commission first allowed for electronic exchanges. As computers began transmitting the trades, a small latency in communication between data centers soon became apparent, and a new form of trading developed that capitalized on this unavoidable flaw.

The trades were made with as little as a seven-millisecond data advantage (the time needed for information to be transmitted between the Chicago and New York markets) ahead of the general public. At fractions of pennies per trade and with larger banking issues for regulators to handle, HFTs have not previously been a priority. While each trade is individually insignificant, these micro-exchanges can collectively cause significant market shift.

Proponents of HFT argue that this form of trade can be beneficial to the market’s overall liquidity, but that perspective has not yet been proven. In a 2013 Forbes interview, industry veterans indicated that HFTs accounted for more than half of all trading in 2012, down from its height of 61 percent in 2009, and are considered to be a significant contributor to the market volatility that led to 2010’s flash crash. According to CNBC, in October 2012, one computer program alone made up to 4 percent of that week’s market trading volume, creating and canceling orders in 25-millisecond increments.

While market-related time advantage methods have been used since the 17th century, when the Rothschilds sent carrier pigeons to transmit information ahead of their competitors, the introduction of digital technology made market-influencing information foreknowledge more profitable, and on a grand scale. And as market-supporting programs and software become more complex, regulators have struggled to keep up with the advances and the advantages they may incur.

Without naming specific companies, Schneiderman’s next focus in the investigation will be on the industries providing undisclosed information and quicker data access to high-speed trading firms. His office will also be examining the loosely regulated private trading venues where large institutional investors, such as Goldman’s Sigma X and Credit Suisse’s (NYSE:CS) Crossfinder, are able to anonymously trade and avoid market impact.

In his remarks, Schneiderman called for the study of market reforms that could stem HFTs. One possibility that will be examined involves discontinuing continuous trade tape in favor of a stop-motion method that would batch exchanges in frequent intervals, making price instead of speed the market’s determining factor.

In response to Schneiderman’s announcement of the new phase of his investigation, Bloomberg reported that the Nasdaq OMX fell 3.1 percent, its biggest single-day drop since last August, when a technical glitch temporarily froze trading for thousands of stocks. Atlanta-based ICE, which owns the NYSE and NYSE Euronext, fell by 1.5 percent.

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