By Peter Schroeder - 07/11/14 12:15 PM EDT
The explosion of high-frequency trading in recent years has chipped away at public confidence in financial markets and forced regulators to up their game to keep up with traders seeking a millisecond edge.
Accusations that lightning-quick traders are gaining an unfair advantage have hurt Wall Street’s public image, but the question of whether the technology is harming ordinary investors is a matter of fierce debate.
The government has opened several investigations into the trades, including inquiries from the Justice Department and Securities and Exchange Commission.
Still, regulators and industry officials alike insist that the markets are not fundamentally tilted against the average investors.
Backers of high-speed trades argue that the influx of technology has been a boon to average investors.
They argue that split-second trades ensure markets are providing the most up-to-date information. The influx of trading at all possible moments actually democratizes the process for regular investors, supporters contend, by ensuring their preferred market moves find a counterparty.
A central challenge for regulators and lawmakers is figuring out exactly what constitutes high-frequency trading. The term is frequently bandied about in public debate as a pejorative, but when it comes time for policymakers to craft rules to rein in misconduct, they face a complicated task.
“High-frequency trading is not some monolithic, homogenous thing. It actually describes a very wide variety of different practices,” said Gregg Berman, the SEC’s associate director of the Office of Analytics and Research.
In the last several years, regulators have spent millions of dollars beefing up their technology and hiring experts in an effort to paint a clearer picture. Both the SEC and the Commodity Futures Trading Commission are pushing Congress for more funding and vowing to set aside significant amounts of it for technology upgrades.
An SEC project known as “Midas,” which began in 2012, pulls 1 billion trading records each day in an attempt to build a real-time picture of what is happening in financial markets down to the fraction of a second. The agency has hired specialists to pore over the information in search of trends and potential problems.
“We’re trying to get away from the dialogue that just says speed is just speed,” said Stephen Luparello, director of the SEC’s division of trading and markets. “Instead, where is the speed coming from? Why is it there? And what are its implications?”
Meanwhile, the Commodity Futures Trading Commission, which monitors the complex derivatives marketplace, is considering requiring high-frequency trading shops to register with the agency and report more information about their operations.
As regulators gather more data about how markets react, officials hope they can further home in on exactly what types of behavior are in need of oversight.
“We should be carefully considering whether there has been illegal conduct. But we also need to revise or create new rules to stop conduct that we think should be illegal,” SEC Commissioner Kara Stein said in April.
In that effort, regulators have the backing of at least some of the high-speed trading shops that are eager to clear their names.
“The markets are just so damn complex that it frustrates people. It confuses people, and they fill in their gaps in knowledge with fear,” said Peter Nabicht, a senior adviser for the Modern Markets Initiative, which represents such traders.
“Let’s focus down on what is it that we don’t like, that’s bad for the market. ... Let’s find that behavior and get rid it. The regulators are doing a very good job of taking a data-driven approach.”
For their part, lawmakers are taking a wait-and-see approach to high-speed trading. Members from both parties are wary of the practice but are not yet ready to bring down the hammer.
“I don’t think we have the answers yet,” said Sen. Sherrod Brown (D-Ohio), a frequent Wall Street critic who could take over as Banking Committee Chairman in 2015.
“I think if we find that there is advantage to some high-frequency traders, then we need to look seriously at it. I just don’t know enough about it,” he said.
High-frequency trading has been on Congress’s radar for years, but action has thus far remained in the information-gathering phase. For the time being, it seems lawmakers are trusting regulators to do the job.
“I’m not sure legislatively there’s anything that needs to be done. You’ve just got to continue to monitor it,” Sen. Saxby Chambliss (R-Ga.) said. “High-frequency trading is not something we’ve been used to for years, so we’re going to continue to watch it.”