Earlier this year the Securities Exchange Commission (“SEC”) levied its first monetary fine against an exchange as part of a $5 million dollar settlement against the New York Stock Exchange (“NYSE”). The SEC found that the NYSE delivered stock-price quotes and other data to subscribers of so called proprietary data feeds seconds before transmitting the same data to the broader market. This gave certain traders an improper head start to act on important market information. Proprietary data feeds had been a favorite resource of high frequency trading (“HFT”) firms whose business model depends on split-second informational advantages. The SEC’s attack on proprietary feeds represents an episode in the struggle to regulate HFT.
HFT firms use computer-based algorithms and ultra-fast processing speed to steer daily trading activity. They derive profits by obtaining information about the market and executing trades much faster than non-HFT competitors. Typically, HFT firms would have to wait for public disclosure of market data before trading on such information because U.S. exchanges are required to submit market data to a centralized network for public dissemination. However, proprietary feeds, like the ones offered by NYSE, allowed firms direct access to information a few seconds before public disclosure. According to Gibson Dunn Partner Barry Goldsmith, permitting access to these NYSE feeds gave HFT firms “potentially unfair advantages.”
Some critics go further than Goldsmith and question whether HFT should be allowed at all. These critics argue that HFT creates two-tiered markets where firms with fast computers trade ahead of market orders to the detriment of all other investors. Even without the NYSE feeds, HFT firms use sophisticated infrastructure to routinely access market data before non-HFT firms. Some strategies include issuing thousands of “immediate or cancel” orders and dark pool pinging. Furthermore, proliferation of HFT practices has been recognized as a cause of the 2010 “Flash Crash” and other market embarrassments like the Knight Capital “Trading Glitch.”
Despite evidence of HFT’s negative impact on markets, the practice does have support. HFT’s proponents claim that the practice has positive effects. Cameron Smith, General Counsel for Quantlab Financial, argues that HFT increases liquidity by increasing trading volumes, thus making it easier to find buyers and sellers of securities. This increased liquidity also lowers trading costs by reducing risk for market makers. Accordingly, Smith believes that HFT firms should not be inhibited by regulation.
The SEC appears content with an intermediate position, allowing HFT firms certain privileges, like server collocation, while directly attacking certain methods it deems as abusive informational advantages, like flash trading and utilization direct data feeds. Though the NYSE settlement and fines may curb the aggressive marketing of data feeds to HFT, unbalanced informational advantages for HFT and market failure risks still remain. The SEC must make difficult decisions in considering what types of advantages it will allow to HFT. As European regulators move to halt HFT completely, it remains to be seen whether the SEC will change its regulatory approach.