There are now two gripping questions before Congressional investigators, the FBI, the Justice Department and the New York State Attorney General's office as they look at High Frequency Trading operations in U.S. markets:
Can markets give the appearance of liquidity while simultaneously being rigged?
How much "liquidity" is being created because the current market structure offers a slam-dunk opportunity for High Frequency Traders to loot the unsophisticated with impunity, thus drawing a steady flow of big money to the looting enterprise?
This, naturally, leads to two final questions: will market liquidity be negatively impacted, and by how much, if the incentive to steal without penalty is removed; has it come down to America having to accept a less liquid market or a market filled with thieves running a wealth transfer system in broad daylight?
On April 4, U.S. Attorney General Eric Holder appeared before the House Appropriations Committee. Congressman Jose Serrano of New York asked Holder what he was doing in regard to high frequency trading. Holder responded:
"As I indicated in my opening statement, I've confirmed that the Department of Justice is looking at this matter, this subject area, as well. The concern is that people are getting an inappropriate advantage, information advantage, I guess competitive advantage, over others because of the way in which the system works. And apparently, as I understand it, and I'm just learning this, even milliseconds can matter, and so we're looking at this to try to determine if any federal laws, any Federal criminal laws, have been broken. This is also obviously something that the head of the SEC, Mary Jo White, would be looking at as well."
The core of the debate centers around the fact that the SEC which oversees stock exchanges has allowed both the New York Stock Exchange and Nasdaq to create a bifurcated market. The unsophisticated investor is given trading data on which to base trading decisions on a slow data feed called the Securities Information Processor or SIP. The SIP is not only slow in getting the data to the technology-challenged investor, but it has limited data. For the rich and powerful on Wall Street who can afford massive fees, there is another data feed offered by the exchanges called the Direct Feed. The Direct Feed data, which has far more useful information, arrives in the hands of High Frequency Traders and Wall Street's proprietary traders ahead of the arrival of the SIP data.
This allows the Direct Feed users to buy a stock on the cheap and sell the stock back to the SIP user at a higher price.
At a Senate hearing on June 18, Senator Elizabeth Warren compared the above to the skimming scam depicted in the movie, Office Space. Warren stated:
"For me the term high frequency trading seems wrong. You know this isn't trading. Traders have good days and bad days. Some days they make good trades and they make lots of money and some days they have bad trades and they lose a lot of money. But high frequency traders have only good days.
"In its recent IPO filing, the high frequency trading firm, Virtu, reported that it had been trading for 1,238 days and it had made money on 1,237 of those days. . .
"High frequency trading reminds me a little of the scam in Office Space. You know, you take just a little bit of money from every trade in the hope that no one will complain. But taking a little bit of money from zillions of trades adds up to billions of dollars in profits for these high frequency traders and billions of dollars in losses for our retirement funds and our mutual funds and everybody else in the market place. It also means a tilt in the playing field for those who don't have the information or have the access to the speed or big enough to play in this game."
The New York Stock Exchange and Nasdaq, which also have a mandated regulatory role to ensure that their markets are fair and non-discriminatory, have allowed the two-tiered market to exist because they are collecting hundreds of millions of dollars a year selling the SIP to the dumb money and the Direct Feed to the smart money.
The exchanges collect tens of millions more by selling co-location services, a system which allows the High Frequency Traders and Wall Street's proprietary trading desks to park their computers in the same warehouse that houses the exchanges computers, providing even speedier access to the Direct Feed data. The New York Stock Exchange boasts: “Colocation has emerged as a highly desirable service for latency sensitive financial trading firms seeking to gain microsecond benefits when trading in today’s competitive electronic markets.”
In another promotional piece aimed at high frequency traders, the New York Stock Exchange brags that it is offering a "fully managed co-location space next to NYSE Euronext's US trading engines in the new state-of-the-art data center." The NYSE says it is for "High frequency and proprietary trading firms, hedge funds and others who need high-speed market access for a competitive edge."
On March 18, New York State Attorney General Eric Schneiderman said in a speech to the New York Law School that these co-location practices at the exchanges are currently under investigation by his office. Schneiderman mentioned that Mary Jo White was in the audience and suggested that she hadn't taken this matter seriously enough or done enough to stop it.
Schneiderman stated: "We know that High Frequency Traders are uniquely able to take advantage of co-location, but there are other services also offered…They [exchanges] supply extra bandwidth, special high-speed switches and ultra-fast connection cables to high-frequency traders, so they can get, and receive, information at the exchanges' data centers even faster. These valuable advantages, once again, give them a leg up on the rest of the market."
At least one law professor, Mercer Bullard, of the University of Mississippi School of Law, believes the intentional creation of a slow data feed (SIP) versus a high-speed data feed (Direct Feed) constitutes illegal insider trading. Bullard is not just any law professor — he served as Assistant Chief Counsel at the Securities and Exchange Commission from 1996 to 2000.
In an OpEd for CNBC on April 4, Bullard said: "In a market dominated by electronic trading, investors are having their pockets picked--and individual investors and mutual fund shareholders are among the likely victims. The securities exchanges’ practice of selling early access to their trading data to insiders--as the term ‘insiders' suggests--is a practice that looks like illegal insider trading."
Bullard's rationale for this statement is hard to debate. Bullard explains that "insider trading occurs when a person trades on material (important), nonpublic information in violation of a legal duty." The trading data coming over the Direct Feed is certainly not public--the public has yet to receive their data on the much slower SIP feed. And key bids and offers that appear on the Direct feed, never make it to the SIP – that data is just not part of the package.
Bullard says the requirement that insider traders have to be trading on material, i.e., very important non-public information, is met by the fact that if it wasn't important information, the insiders with the Direct feeds couldn't be reaping "huge profits" on it.
Expect to hear a lot more about all of this when Congress comes back from summer recess.