In search of HFT boogeyman

New York’s top law enforcer has opened a broad investigation into whether U.S. stock exchanges and alternative venues provide high-frequency traders with improper advantages, a person with direct knowledge of the matter said.

Attorney General Eric Schneiderman is examining the sale of products and services that offer faster access to data and richer information on trades than what’s typically available to the public, according to the person. Wall Street banks and rapid-fire trading firms pay thousands of dollars a month for these services from firms including Nasdaq OMX Group Inc. and IntercontinentalExchange Group Inc.’s New York Stock Exchange.

The attorney general’s staff has discussed his concerns with executives of Nasdaq and NYSE and requested more information, said the person, who asked not to be named because the inquiry hasn’t been announced. Schneiderman’s office is also looking into private trading venues, known as dark pools, and the strategies deployed by the high-speed traders themselves.

“This new breed of predatory behavior gives a small segment of the industry an enormous advantage over all other competitors and allows them to use new technologies to reap huge profits based on very, very minor, but nonetheless unfair, advantages,” Schneiderman said today at New York Law School during a speech in which he described his concerns with trading. He said he looked forward to working with other regulators on the issue, while saying his office would keep looking for “unseemly” practices.

Disrupting Strategy

The investigation threatens to disrupt a model that market regulators have openly permitted for years as high-speed trading and concerns about its influence have grown. Trading firms pay to place their systems in the same data centers as the exchanges, a practice known as co-location that lets them directly plug in their companies’ servers and shave millionths of a second off transactions. They also purchase proprietary data feeds, which are faster and more detailed than the stock- trading information available on the public ticker.

“We publicly file with the SEC for each and every one of these services, and we’re always engaged with government officials around the world,” Robert Madden, a spokesman for New York-based Nasdaq, said in a phone interview, referring to the U.S. Securities and Exchange Commission. He and Eric Ryan, a spokesman for NYSE, declined to comment on Schneiderman’s investigation.

Nasdaq Falls

Shares of Nasdaq today dropped as much as 4 percent, its biggest intraday drop since an Aug. 22 technical malfunction at the exchange forced it to temporarily halt trading for thousands of companies. ICE, which purchased the New York Stock Exchange in November when it acquired NYSE Euronext, fell as much as 1.3 percent today and was down 0.7 percent as of 10:43 a.m. New York time.

Dark pools, including Goldman Sachs Group Inc.’s Sigma X and Credit Suisse Group AG’s Crossfinder, operate without the same regulatory oversight as the public exchanges and disclose little about their trading or the participants. Bloomberg News parent Bloomberg LP owns a stake in Bids Trading LP, which operates a dark pool. Michael DuVally, a spokesman for New York- based Goldman Sachs, declined to comment, as did Drew Benson, a spokesman for Zurich-based Credit Suisse.

“My office is going to continue to shine a light on unseemly practices” in high-speed trading, Schneiderman said during his speech in New York today. “I look forward to joining with other regulators and my colleagues in government in taking real, concrete steps to deal with this problem. We’ve had some inquiries and ideas floated by the SEC” and U.S. Commodity Futures Trading Commission, “but it’s time for us all collectively to step up to this challenge.”

Flash Crash

Special services have helped fuel high-frequency trading, in which computer programs execute orders in a fraction of a second and take advantage of fleeting discrepancies in security prices across trading venues. High-frequency activity represented more than half of all U.S. stock trading in 2012, according to Rosenblatt Securities Inc.

Critics including some regulators and market participants say that such trading, which captured the spotlight in the May 2010 flash crash in U.S. equities, serves little purpose, may distort the market and may leave retail investors at a disadvantage.

Human Eye

Computer-driven trades can be executed in about 300 microseconds, according to one study. At that speed more than 1,000 trades can be made in the blink of a human eye, which lasts 400 milliseconds. At their peak, algorithms shot out about 323,000 stock-trading messages each second in the U.S. last year, compared with fewer than 50,000 for the busiest period in 2007, according to data compiled by the Financial Information Forum.

Andrew Brooks, head of U.S. equity trading at Baltimore, Maryland-based T. Rowe Price Group Inc., told a Senate hearing in late 2012 that the quest for speed has threatened the market.

Proponents say that high-speed trading actually increases the availability of shares in the market and that interfering with such programs would lead to higher costs and be harmful to financial stability. Indeed, the rise of computers in stock trading has helped squeeze out specialists and market makers, who had long facilitated transactions.

The current market structure, which has led to more participants, has lowered the cost of trading for investors, said Peter Nabicht, a spokesman for Modern Markets Initiative, an industry group formed last year by firms including Quantlab Financial LLC, Hudson River Trading and Global Trading Systems.

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