Faced with a series of technical glitches ranging from the
flash crash to the software errors that cost Knight Capital
$440 million last month, the Securities and Exchange Commission
is holding a technology roundtable to see
what can be done to prevent future trading
The agency, which has not disclosed who will participate,
said the session will focus on preventing errors,
especially in systems that are used to generate trades, confirm
transactions and disseminate data. The roundtable will be held
at the SECs headquarters on October 4.
The meeting will also discuss how the market might use
crisis management procedures to detect, limit and
possibly terminate erroneous market activities.
The series of trading glitches, which began with the
Flash Crash in 2010, has driven many small
investors from the stock market because they believe they are
at a disadvantage to high frequency traders, who now account
for more than 70 percent of all equity turnover.
The situation may be worse than small investors fear.
According to a new book, even institutional investors now have
to take a back seat to high frequency firms, which are accorded
special trading status by many exchanges in return for their
The SEC has had a proposed regulation under consideration
since 2009, which would limit some of the advantages granted to
high frequency traders, but the rule has never been
The book is entitled Dark Pools, by Wall
Street Journal reporter Scott Patterson. The title is a
misnomer because the book has relatively little to do with dark
pools the off-exchange trading sites that allow
investors to trade anonymously without posting prices.
Patterson maintains that the entire market has become a dark
pool of sorts because the actions of high frequency traders are
invisible to virtually everyone.
Much of Pattersons argument is based on information
from Haim Bodek, who founded a high-speed trading firm called
Trading Machines to trade in stock options. Bodek eventually
was forced to close the firm because of continuing losses.
Patterson says he also interviewed executives at exchanges
about the trading practices.
The author maintains that high frequency traders enjoy two
advantages over other investors in the stock market. One is
that through a system known as colocation in which they
place their computers next to exchange computers they
connect to a data stream that alerts their computer algorithms
to trades ahead of anyone elses computers.
Although the problem of colocation has been debated for some
time, Bodek told Patterson that an exchange official admitted
to giving the high frequency traders another, unknown
advantage. The traders have been made aware of specific types
of trading orders that will jump to the head of the trading
As outlined by Bodek and Patterson, when a large mutual fund
such as Fidelity wants to place a large bloc trade, for
instance, to buy one million shares of IBM, the company breaks
the trade into many smaller trades and spreads them out in an
effort to disguise their intent from the computer programs
searching through trades on the network.
But according to Patterson, high frequency traders
algorithms are now so sophisticated they are able to deduce
from a small trade order that a bigger transaction is in
progress. A classic short-term strategy is to sniff out
an elephant and trade ahead of it, he writes.
The computer then knows to place a buy order of a special
type that leapfrogs over the mutual funds transaction to
the front of the trading queue. When the mutual fund order is
finally processed, it is at a slightly higher price because the
high frequency traders order has already minutely driven
up the price. The high frequency trader then sells the stock at
that higher price, and the value of the shares declines.
Bodek became convinced that the market was
rigged, Patterson writes. When I asked Patterson, who
worked for three years on the book, if he agreed with that
assessment, he was cautious. It looks very
suspicious, he said. We have to rely on the
regulators to go in and look at the records.
What Patterson is describing is basically a form of front
running. According to him, most large institutions still use
limit orders, which set a cap on the price the buyer will pay
for a stock. The other alternative is a market order, which
will buy a stock at whatever the price is in the market when it
According to information in the book, high frequency traders
have been told to use a specialized hybrid trade that is
neither a limit nor a market order. That particular kind of
trade, which most traders have never heard of, jumps the order
to the front of the trading queue ahead of limit orders,
No big institution would ever use this type of
order, Patterson says. The high frequency traders
use them to get priority and a rebate [for their trading
Patterson says regulators are investigating whether this
type of order is giving the high frequency traders an unfair
advantage. So many firms now use these orders, he says, that
they are constantly jamming up against each other at the top of
the trading queue. Its the big institutional firms that are
stuck behind them and suffer a price disadvantage when their
trades eventually clear, he says.
One of the arguments in favor of high-speed trading firms
has always been that they help narrow the spreads between the
bid and ask price, making stock purchases cheaper for everyone
in the market. But if indeed institutional investors' trades
are being forced behind the high frequency trades, they are
paying a premium that would not otherwise exist.
Patterson reckons that algorithms now account for about two
thirds of all trades in the stock market.
Another advantage that the high frequency firms are allowed
is that their trades are invisible to all other traders, so big
institutions monitoring the market cant tell whether
their strategy has been discovered and others are bidding
Why are high frequency traders given so many advantages by
the exchanges? According to Patterson, the firms generate so
much business for the exchanges that they actually get paid by
the high frequency firms, rather than the other way around.