Insider trading, now at high speed

When Michael Lewis’s Flash Boys , an enthralling and scathing picture of what he warned was a “rigged” US market — focusing on high frequency trading (HFT), dark pools and an attempt to offer investors an alternative — was published earlier this year, many within the industry were quick to rubbish the stark portrait of the market.

His claims, which included the contention that high frequency traders — using high-speed technology and physical proximity to the numerous stock exchanges that have sprung up over the years — were able to exploit the differences in pricing and front run, or get ahead of orders being placed by others, was described by one HFT firm CEO as “annoying and harmful” “fiction”.

Over the years, concerns about dark pools — off-exchange trading venues run mostly by investment banks, which offer a degree of anonymity to trade in by not immediately publicly revealing trades — have also been brushed aside by industry bigwigs.

“The argument that dark pools are somehow part of the high frequency trading debate simply does not make sense,” Daniel Mathisson, a senior Credit Suisse Executive told a US senate committee in testimony a few years ago. “High frequency traders make their money by digesting publicly available order information faster than others; dark pools hide order information from everyone.

Like many of the recent controversies in the financial market, concerns seem to have proven spot on, and both HFT and dark pools have returned to the spotlight in the past couple of weeks, in yet another blow to the reputation of the banking sector and financial markets.

Last week, New York Attorney General Eric Schneiderman initiated a lawsuit seeking unspecified monetary damages against Barclays over alleged “fraud and deceit” at its LX Liquidity Cross, at the time one of the largest dark pools in the US.

In a detailed 30-page-complaint, the Attorney General painted a worrying picture of the bank’s alleged courting of “predatory” high frequency traders into the dark pool, while putting other investors to disadvantage.

The complaint also alleges that Barclays shared information with high frequency traders that helped “maximise the effectiveness of their aggressive trading strategies” in the dark pool — information that was not shared with others.

Further hurting the reputation of dark pools was last week’s $800,000 fine imposed by the US banks’ self-regulating Financial Industry Regulatory Authority on Goldman Sachs for failing to find its clients the best-quoted price on its dark pool SIGMA-X in nearly 400,000 orders between July 29, 2011 and August 2011.

There are a number of takeaways from the recent revelations.

First, and perhaps most importantly, the charges levelled against dark pools and HFT point to the unintended consequences that regulations can often have.

Lewis, for example, argues that regulatory changes introduced to promote competition amongst exchanges — which allowed for the creation of dozens of exchanges and off-exchange dark pools — had created the perfect conditions for high frequency traders to be able to front run, exploiting the different times it took orders to be sent to the different exchanges. Another requirement — that brokers find the investor the best bid or offer — added to the ease with which this could be done.

Undoing or limiting the impact of changes can be hard. Europe, which introduced legislation to open up competition in the exchange market back in 2007, is now considering putting a cap on dark pools (limiting the volume of a particular stock that can be traded on dark pools to 8 per cent) while in the US the Securities and Exchange Commission is considering a number of proposals including to require greater disclosure of information on dark pools and the trading within them.

Another startling thing that has emerged in the whole dark pool/HFT debate is the extent to which the markets have changed in the past decade, in many cases beyond even the understanding of seasoned investors and traders.

Lewis, for one, chronicles the way in which Brad Katsuyama, an experienced Royal Bank of Canada trader (who went on to found IEX, an exchange designed to protect investors from front running) began with little idea of the sheer dominance of high frequency traders, and crucially, the importance of speed and every nano and millisecond when it came to executing trades.

Many investors Katsuyama spoke to after he began marketing IEX seemed equally in the dark, despite using the systems every day, and had long been perplexed with the way orders were routed and executed across the numerous exchanges and dark pools with their different incentive and charging systems (Lewis also chronicles the way in which high frequency traders were incentivised to participate as part of a trading venue’s efforts to boost trading volumes and profits).

The difficulty of untangling the crazily complex US market that has developed in recent years was highlighted by regulators’ efforts to explain the flash crash of 2010, when the Dow Jones Industrial Average fell nearly 1,000 points in a matter of minutes, before bouncing back again. While regulators published a report the same year, focusing on a single trade, many believed it underestimated the role played by high frequency traders.

Another troubling aspect is the laxity with which regulatory authorities seem to have approached potential abuse, despite the great public scrutiny financial markets and banks have been subject to since the 2007 crisis.

While regulators and law enforcement authorities have certainly become more vocal — particularly since the publicity accorded to Lewis’ book — certain things stand out.

For example, Lewis highlights the eagerness with which authorities pursued a Goldman Sachs computer programmer for stealing a code related to the company’s HFT systems, with far more zeal than they had in assigning culpability for the 2007 crisis.

And these things matter for those well beyond the industry: by according advantages to those with the means, and the speed, ordinary investors and those with stakes in pension funds lose out. “What had once been the world’s most public, most democratic, financial market had become, in spirit, something more like a private viewing of a stolen work of art,” writes Lewis.

Regulators have long been willing to give firms in the financial sector and its frontiers the benefit of the doubt despite the numerous times they have proved remarkably adept at finding ways to milk the system.

SEBI has long been mistrustful of dark pools, keeping them out of the Indian market, even as they have spread to other parts of Asia (in Singapore, Hong Kong and Japan they compromise a small part of the market, against accounting for an estimated 40 per cent of trading in the US).

A position that regulators across the world may increasingly see as very prudent.

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