New York’s top law enforcer has opened a broad investigation into whether U.S. stock exchanges and alternative venues provide high-frequency traders with improper advantages, a person with direct knowledge of the matter said.
Attorney General Eric Schneiderman is examining the sale of products and services that offer faster access to data and richer information on trades than what’s typically available to the public, according to the person. Wall Street banks and rapid-fire trading firms pay thousands of dollars a month for these services from firms including Nasdaq OMX Group Inc. and IntercontinentalExchange Group Inc.’s New York Stock Exchange.
The attorney general’s staff has discussed his concerns with executives of Nasdaq and NYSE and requested more information, said the person, who asked not to be named because the inquiry hasn’t been announced. Schneiderman’s office is also looking into private trading venues, known as dark pools, and the strategies deployed by the high-speed traders themselves.
“This new breed of predatory behavior gives a small segment of the industry an enormous advantage over all other competitors and allows them to use new technologies to reap huge profits based on very, very minor, but nonetheless unfair, advantages,” Schneiderman said today at New York Law School during a speech in which he described his concerns with trading. He said he looked forward to working with other regulators on the issue, while saying his office would keep looking for “unseemly” practices.
The investigation threatens to disrupt a model that market regulators have openly permitted for years as high-speed trading and concerns about its influence have grown. Trading firms pay to place their systems in the same data centers as the exchanges, a practice known as co-location that lets them directly plug in their companies’ servers and shave millionths of a second off transactions. They also purchase proprietary data feeds, which are faster and more detailed than the stock-trading information available on the public ticker.
“We publicly file with the SEC for each and every one of these services, and we’re always engaged with government officials around the world,” Robert Madden, a spokesman for New York-based Nasdaq, said in a phone interview, referring to the U.S. Securities and Exchange Commission. He and Eric Ryan, a spokesman for NYSE, declined to comment on Schneiderman’s investigation.
Shares of Nasdaq today dropped as much as 4 percent, its biggest intraday drop since an Aug. 22 technical malfunction at the exchange forced it to temporarily halt trading for thousands of companies. ICE, which purchased the New York Stock Exchange in November when it acquired NYSE Euronext, fell as much as 1.3 percent today and was down 0.7 percent as of 10:43 a.m. New York time.
Dark pools, including Goldman Sachs Group Inc.’s Sigma X and Credit Suisse Group AG’s Crossfinder, operate without the same regulatory oversight as the public exchanges and disclose little about their trading or the participants. Bloomberg News parent Bloomberg LP owns a stake in Bids Trading LP, which operates a dark pool. Michael DuVally, a spokesman for New York-based Goldman Sachs, declined to comment, as did Drew Benson, a spokesman for Zurich-based Credit Suisse.
“My office is going to continue to shine a light on unseemly practices” in high-speed trading, Schneiderman said during his speech in New York today. “I look forward to joining with other regulators and my colleagues in government in taking real, concrete steps to deal with this problem. We’ve had some inquiries and ideas floated by the SEC” and U.S. Commodity Futures Trading Commission (CFTC), “but it’s time for us all collectively to step up to this challenge.”
Special services have helped fuel high-frequency trading, in which computer programs execute orders in a fraction of a second and take advantage of fleeting discrepancies in security prices across trading venues. High-frequency activity represented more than half of all U.S. stock trading in 2012, according to Rosenblatt Securities Inc.
Critics including some regulators and market participants say that such trading, which captured the spotlight in the May 2010 flash crash in U.S. equities, serves little purpose, may distort the market, and may leave retail investors at a disadvantage.
Computer-driven trades can be executed in about 300 microseconds, according to one study. At that speed more than 1,000 trades can be made in the blink of a human eye, which lasts 400 milliseconds. At their peak, algorithms shot out about 323,000 stock-trading messages each second in the U.S. last year, compared with fewer than 50,000 for the busiest period in 2007, according to data compiled by the Financial Information Forum.
Andrew Brooks, head of U.S. equity trading at Baltimore, Maryland-based T. Rowe Price Group Inc., told a Senate hearing in late 2012 that the quest for speed has threatened the market.
Proponents say that high-speed trading actually increases the availability of shares in the market and that interfering with such programs would lead to higher costs and be harmful to financial stability. Indeed, the rise of computers in stock trading has helped squeeze out specialists and market makers, who had long facilitated transactions.
The current market structure, which has led to more participants, has lowered the cost of trading for investors, said Peter Nabicht, a spokesman for Modern Markets Initiative, an industry group formed last year by firms including Quantlab Financial LLC, Hudson River Trading and Global Trading Systems.
“Speed of decision-making and execution, often associated with high-frequency trading, gives traders more confidence in their interaction with the market, which allows them to efficiently make more competitive prices” and better meet investor demands, Nabicht said.
Schneiderman has previously voiced disapproval of services that cater to high-speed traders and give them a potential edge. When Business Wire, the distributor of press releases owned by Warren Buffett’s Berkshire Hathaway Inc., said last month it would stop sending the statements directly to high-frequency firms, Schneiderman called it “a tremendous victory.”
Taking his concerns public may help Schneiderman push the exchanges to alter practices, as Business Wire did, even without enforcement action. Among the powerful tools at his disposal is the Martin Act, an almost century-old law that gives him broad powers to target financial fraud in the state.
Targeting the exchanges could be the most straightforward way to deal with any ill effects of speedy trading, said James D. Cox, a securities law professor at Duke University in Durham, North Carolina.
“The exchanges are much more vulnerable to state and federal regulatory enforcement than the market participants,” Cox said. “They have a broad statute to maintain orderly markets and to do so in an ethical manner.”
The 1934 securities law that set up regulatory oversight of the U.S. financial markets specifies that exchanges enact rules to protect investors and the public’s interest, to promote equitable practices and to prevent fraud and manipulation.
Regulators have signaled concerns in recent years on how U.S equity markets operate. After the Dow Jones Industrial Average briefly lost almost 1,000 points in the flash crash, the chairman of the SEC, Mary Schapiro, said she planned to increase scrutiny of high-frequency traders.
In an effort to avoid another flash crash, the SEC worked with exchanges to create price curbs designed to prevent losses in a single stock from snowballing into a marketwide rout. The current chairman, Mary Jo White, said in January the SEC would soon publish a review of research on high-frequency trading. The CFTC, which oversees U.S. derivatives markets, announced a review of high-speed trading last year.
Cox, the Duke professor, said New York’s attorney general is the only law enforcement body or regulator likely to target the exchanges.
“The SEC wants to protect investors, but also strengthen and promote U.S. capital markets,” Cox said. “These twin functions conflict with each other, which is why they have so far turned a blind eye on this issue.”
Some in the trading business, like Joe Saluzzi, a partner and co-head of equity trading at Themis Trading LLC in Chatham, New Jersey, have called for restraining services. Saluzzi said he’s wary of the private feeds because they’re far more detailed than public data, showing when and how a stock order was changed or canceled, which can give an insight into a particular strategy.
“Inside these data feeds is information which allows folks to read it and re-engineer the behavior of others,” Saluzzi said. “A lot of high-frequency strategies are built on modeling the behaviors of someone else.”
The private feeds also reach traders more quickly than the public-quote system because they are sent directly from each exchange to paying customers. Public feeds build in an additional step: Price data from dozens of venues where U.S. stocks change hands are sent to a central place for processing before that information is publicized. Bloomberg LP, the parent of Bloomberg News, provides its clients with access to some proprietary exchange feeds.
A study published in January co-authored by Terrence Hendershott, associate professor of finance at the University of California, Berkeley, found the average time difference was 1.5 milliseconds between calculating a stock’s price using the exchange’s proprietary data and waiting for the public information. That’s more than enough time for a speedy trader to recognize an advantageous price and execute a trade against someone using the slower feed.
During his speech, Schneiderman referred to an academic paper that suggests segmenting the trading day into thousands of auctions in an effort to prevent the quickest firms from jumping ahead of others.
The paper’s co-author, Eric Budish, associate professor of economics at the University of Chicago’s Booth School of Business, told Bloomberg News in February that non-stop markets create a race between speed traders.
Operating different data feeds has led to past disciplinary action. NYSE Euronext agreed to pay the SEC $5 million in September 2012 to resolve claims it violated rules by giving some customers a head start on trading information. NYSE sent data through proprietary feeds to paying customers before relaying the same information to the public feed, regulators said. The exchange said the incident was “not from intentional wrongdoing.”
The exchanges have a variety of duties and responsibilities not just to the public, but to members and shareholders. NYSE and Nasdaq are required to police their members’ activities. In the past decade, they have moved from member-owned utilities to publicly traded companies with an eye on generating returns for shareholders.
Nasdaq said in an investor presentation last week that it had close to $40 million in revenue from U.S. proprietary market data in the fourth quarter last year. The company does not reveal how much it receives from co-location of servers.
The use of high-frequency trading strategies has come under scrutiny outside the U.S.
European Parliament lawmakers reached a draft deal with national governments to curb high-frequency trading as part of tougher rules for the bloc’s financial markets, said the chief legislator working on the plans in October. The draft requires algorithms to be tested and authorized by regulators and calls for circuit breakers, among other measures.
“The negotiation team achieved a significant breakthrough on this issue,” Markus Ferber, the lawmaker leading the measures, said in an e-mail at the time. “The area of high-frequency trading is lacking suitable regulation.”