By Kam Segawa*
In 2014, after Michael Lewis published Flash Boys: A Wall Street Revolt, he went on 60 Minutes and plainly stated that the United States Stock market was “rigged.”[i]His assertion was that public and private exchanges were giving special access to data to high-frequency traders (HFTs) at the expense of the general public.[ii]In response, various measures have been proposed or enacted to combat the prevalence of HFTs in the marketplace.[iii]Although these measures on the face make sense, they often fail to mitigate the problems created by such trading, while also reducing its benefits. Instead, the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) should increase disclosure requirements of both public and private exchanges, so investors have a better sense of the actors in the marketplace in which they will be trading and can make their own informed decisions whether or not to participate in the market.
One of the biggest problems that HFTs pose to the general public is front-running.[iv]In a large transaction, it is common for an order to not be able to be fulfilled on one exchange. For example, image the hypothetical, typical investor A would like to purchase 1000 shares of stock S at the current best price. On exchange X, there could be a standing order by a third party to sell 500 shares of stock S at 10.25. On exchange Y, there is another order placed by the HFT firm to sell 500 shares at 10.25. Investor A would need to split up the transaction between three different orders in order to fulfill his desire to buy 1000. What he doesn’t know is that HFT investor B, is sitting in a colocation right outside of the exchange and will have access to the information before A does. The routing times for these orders matter. If the order to buy 500 shares on exchange X takes ten microseconds. While the routing times for exchange Y are 26 microseconds, it gives B a 16-microsecond opportunity to exploit A’s desire. Once B sees the first order come off the books on exchange X, it can infer, using its own algorithms, that an investor may be interested in buying the rest of the shares on exchange Y. With this information, and the 16-microsecond head-start, it can cancel the order to sell the shares of stock S at exchange Y at 10.25 and place another order to sell it for 10.26. Typical investor A will have to pay a premium for the additional 500 shares of stock he will want to purchase.
It is important to understand how the HFTs know where to position these orders to utilize any delay in order processing. Connecting all these exchanges are fiber optic networks that are traveling at nearly the speed of light. The only limiting factor for data transfer is the actual physical length of the fiber optic cables between where the orders are being routed from and their destination.[v]Most exchanges offered a premium location, right outside the exchange, so some investors, in our case HFTs, would have the first look at the data before anyone else. This gives them the opportunity, to exploit other investors without access to that data.
There are various proposals to address this “unfairness” in the market. Some have proposed a minimum order resting time.[vi]The idea behind this proposal is a minimum resting time would increase the likelihood of the order being filled and prevent the ‘phantom liquidity’ problem posed in the example above. Stock S at exchange Y cannot be cancelled by the HFT firm unless that order has been on the books for a specified amount of time. It would increase the transaction costs for HFT to enter and exit the market and only let place orders on the underlying fundamentals of the stock. But removing the flexibility to cancel orders would hurt all the actors in the market. In our example, if the market moves and the order on exchange X becomes stale, with minimum order resting times, the third party would have to wait until that time expires before it can cancel or modify that order. At that time, the HFT would actually be best positioned to take advantage of the bad price. The idea that the SEC would simply need to impose new rules to deal with HFTs is misguided.
Ultimately, the most sophisticated traders will always have an advantage over the common trader. Even if SEC can outlaw access to closer data centers and “fast” lanes, proprietary software strategies can give some companies a speed advantage without needing to co-locate in a nearby data center. ‘Tick-to-trade’ measurements, from when an order is received from the exchange to when it executes on it, can be less than a microsecond.[vii]Should the SEC artificially slowdown these solutions, so some companies are able to fill their orders at the same rate? The best solution is to simply require all exchanges, public and private, to disclosure certain benchmarks that help shed light unto whether HFTs are engaged in predatory trading. Fill-rates, order-to-execution ratios, and order-resting times are some ways to clue an ordinary investor in on what kind of actors are trading in an exchange. Investors have the power to exit markets they believe are unfair and enter markets that are taking steps to protect ordinary investors from predatory trading. Instead of simply mandating rules for exchanges to follow, the regulating authorities should require more detailed and comprehensive disclosures to help investors make their own decisions.
The disclosure requirements by the exchange’s dark pools would also need to be increased and closely monitored. In the aftermath of the explosion of HFTs, many trading firms represent to their clients that they route their orders in a way that would avoid the predatory practices of the HFTs. Deutsche Bank, late in 2016, was fined $37 million for misleading investors about how it ranked trading venues.[viii]It was important that Deutsche Bank was held responsible for this false representation to its clients, but the alleged activity took place between January 2012 and February 2014.
A more stringent disclosure requirement could have alerted investors to this activity much sooner. But the increased disclosure requirement would also help investors bring private civil actions for these fraudulent misrepresentations. The more information that is publicly available, the easier for private actions to survive a motion to dismiss under higher pleading standards of Iqbal.[ix]
We have already started seeing exchanges take steps to protect investors. Investors Exchange (IEX) was founded in 2012 to help combat the issues of HFTs front-running normal investors. They use a delay reporting mechanism, which would prevent the HFTs from manipulating a timing advantage as in the example above.[x]The reporting of the initial 500 share trade would be delayed, allowing the additional order on exchange Y to be filled before the HFT could notice. Although IEX only represents 2% of the total trading activity, NYSE, with its much larger market share, recently received regulatory approval to implement its own ‘speed-bump’ exchange on one of its platforms.[xi][xii]The market will implement its own reforms, as long as investors are given enough information to make an informed choice about which exchange to participate in.
*Kam Segawa is a Junior Editor on MJEAL. He can be reached at firstname.lastname@example.org
The views and opinions expressed in this blog are those of the authors only and do not reflect the official policy or position of the Michigan Journal of Environmental and Administrative Law or the University of Michigan.
[i]60 Minutes: Rigged (CBS television broadcast, Mar. 30, 2014).
[iii]DEVELOPMENTS IN BANKING AND FINANCIAL LAW: 2013: VIII. Dark Pool Regulation, 33 Rev. Banking & Fin. L. 69.
[iv]Article: THE NEW STOCK MARKET: SENSE AND NONSENSE, 65 Duke L.J. 191, 195
[v]On A ‘Rigged’ Wall Street, Milliseconds Make All The Difference, NPR (Apr. 1 2014), https://www.npr.org/2014/04/01/297686724/on-a-rigged-wall-street-milliseconds-make-all-the-difference
[vi]ARTICLE: IMPLEMENTING HIGH FREQUENCY TRADING REGULATION: A CRITICAL ANALYSIS OF CURRENT REFORMS, 6 Mich. Bus. & Entrepreneurial L. Rev. 201
[vii]Paul Spencer, “’Tick to Trade’ – is it the new must have metric in trading performance?,” VELOCIMETRICS (May 31, 2018), http://www.velocimetrics.com/tick-to-trade-is-it-the-new-must-have-metric-in-trading-performance/.
[viii]Aruna Viswanatha, Deutsche Bank to pay to end ‘Dark Pool’ probe, Market Watch, (Dec 19, 2016).
[ix]Ashcroft v. Iqbal, 556 U.S. 662, 686 (2009).
[x]Cezary Podkul, Study Finds ‘Speed Bumps’ Help Protect Ordinary Investors, Wall. St. J. (June 14, 2018), https://www.wsj.com/articles/study-finds-speed-bumps-help-protect-ordinary-investors-1528974002.
[xi]Frank Chaparro, There’s been an executive shake-up at upstart stock exchange IEX as it struggles to attract a listing, Business Insider(May 23, 2018), https://www.businessinsider.com/theres-been-an-executive-shakeup-at-upstart-stock-exchange-iex-as-it-struggles-to-attract-a-listing-2018-5.
[xii]John McCrank, NYSE wins regulatory approval for ‘speed bump’ exchange, Reuters, (May 16, 2017), https://www.reuters.com/article/us-nyse-exchange-speedbump-idUSKCN18C2UC.