Do Computerized Trading Platforms Yield an Unfair Advantage?

RENAISSANCE TECHNOLOGIES“Federal securities regulators are examining whether some sophisticated, rapid-fire trading firms have used their close links to computerized stock exchanges to gain an unfair advantage over other investors, people familiar with the matter say,” according to the Wall Street Journal Friday, March 23. “The wide-ranging probe, being handled by the enforcement staff of the Securities and Exchange Commission, is focusing on the computer-driven trading platforms of exchanges, including BATS Global Markets Inc.”

The probe is the most recent effort by the SEC to examine areas of the securities markets that are less transparent but yields an unfair advantage nonetheless. In the case of computerized trading platforms, technologically savvy investors are able to trade fast than their less technologically capable counterparts, sometimes executing buys and sells in a window of mere seconds – a phenomenon usually referred to as rapid-fire trades. The SEC’s interest in the matter was peaked after the “flash crash” in May 2010, when stocks fell sharply then rebounded within minutes after glitches in computer trading systems.

Computer-driven exchanges like BATS are the favorite trading venue for these sorts of high-speed trades, so much so that BATS is the third most popular trading venue in the US, falling just behind the NYSE Euronext and Nasdaq OMX. Of particular interest to the SEC is the communications that take part between these exchanges and the trading firms that specialize in higher frequency trading. According to the Wall Street Journal, “Investigators are examining whether firms collude to limit competition or manipulate markets, according to a person familiar with the matter.”

The review is still in the early stages – there is no suggestion of wrongdoing and no charges have been filed – but the implications of the SEC’s findings could be huge. Granted, right now the focus is on the exchanges and their communications between high-frequency trading firms, but if the SEC finds that high frequency trading presents an unfair advantage where will that line be between technologically advanced and criminally advantaged? And, what then of the firms and even private investors that use high frequency trading?

Will private investors lose the ability to schedule trades when certain triggers are met? Maybe so. It is certainly an advantage to automate a trade – as easy as do-it-yourself trading platforms are, there are still those that find such functions to be over their heads. What about hedge funds? There is a lot of hedge funds that use high frequency trading – Jim Simons’ Renaissance Technologies and Ken Griffin’s Citadel Investment Group are great examples. Will an SEC finding mean that they have to change their methods?

The Wall Street Journal reports that the fees involved in high frequency trading are also under question. “Firms that send orders to exchanges that help complete a trade are paid a small rebate, typically about 30 cents per hundred shares. Some high-frequency firms specialize in such trading, commonly known as rebate trading, which requires extremely fast connections to exchanges to achieve success and consistency.” Reportedly, “Other firms that trade aggressively—typically mutual funds or hedge funds—are charged a slightly higher fee by exchanges. Exchanges in recent years have rolled out a number of complex order types that determine how investors’ buy and sell orders are treated within their computerized “matching engines.”

If these exchanges are required to charge consistent fees, will that improve the bottom lines of the hedge funds and mutual funds that were forced to pay a bit more? Even if the difference is just a penny per transaction, with the volume many of these firms deal in the difference would quickly add up.

It is too early to say how any of this will go but it is definitely a development of which to be aware.

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