The SEC still hasn’t stopped manipulative high speed traders from ripping off investors, even though the abuses have been self-evident for years to anyone paying attention.
A series of events have brought the subject of high frequency trading abuses once again to the forefront of the financial news reportage. These events include:
- The recent arrest of Navinder Sarao, a British trader, who has been accused of being complicit in the infamous “flash crash” that occurred five years ago. Within minutes, the May 10, 2010 incident sent the Dow tumbling almost 1000 points before it recovered, sending shockwaves throughout our financial markets.
- The recent Initial Public Offering by Virtu Financial rekindled outrage that firms, which engage in high frequency algorithmic (HFA) trading, are cheating investors with impunity and have been doing so for nearly a decade. It is hard to accept that a trading company like Virtu only suffered one losing trading day over a six-year period without manipulating the market. A number of investment banks have reported similar improbable results.
- The biting repercussions stemming from Michael Lewis’s book, Flash Boys, which exposed the practices of predatory high frequency traders, have not subsided since the book was released.
Although the SEC has investigated high frequency trading and its impact on the market for years, it is yet to explain, never mind halt, the inexplicable streaks of consecutive winning trading days that banks and hedge funds routinely report. On the other side of every winning transaction is an investor, who is losing money and none too happy about it. Where are the market watchdogs that are supposed protect investors from predatory trading? Perhaps, the following fictitious meeting might explain why they are missing in action:
In the wake of withering criticism that market regulators are turning a blind eye to the abuses of manipulative high frequency traders, senior officials have gathered in the war room at the Securities and Exchange Commission. The mood is tense. In the room are representatives from the U.S. Commodity Futures Trading Commission and several disciplines including a securities law specialist (lawyer), an ex-Wall Street executive (wise guy), an ambitious by-the-book regulator (enforcer), and a political operative from the White House (politician). Let’s listen in on their conversation.
Politician: “The White House has been inundated with angry phone calls and emails wanting to know how it is possible that banks and hedge funds are able to rack up statistically improbable trading gains almost every single day using computer software and high frequency signals. The Press Secretary is doing his level best trying to deflect questions from the media but he cannot hold them off forever. The integrity of our financial markets is being questioned. We need answers and we need them quickly. This has been going on way too long. The media and the public are wise to the obscene profits being raked in 24/7 by firms that engage in this kind of trading. They are irate that nothing is being done about it after all the years the SEC has spent investigating the issue. What the hell is going on?”
Lawyer: “To answer your question, please note that the SEC convened a special board of inquiry to investigate the matter back in 2010 when the flash crash occurred. We quickly determined that a large sell order from a firm in Kansas caused a trading imbalance, which precipitated a temporary dislocation in market activity. We recently indicted a British trader, whom we believe had also contributed to the crash. He has been arrested and we are awaiting his extradition to the U.S. Our task force continues to investigate other instances where high frequency trading has caused unusual activity in certain stocks and overall market behavior.”
Politician: “How come it is taking years to put an end, once and for all, to this nefarious activity?”
Lawyer: “Because of the complexities involved, these kinds of investigations, by their very nature, take a long time. That’s why it took us five years to build a case against Mr. Sarao before issuing a warrant for his arrest. Rest assured that the SEC is diligently trying to ferret out charges of abusive trading practices by high speed traders and bring the perpetrators to justice. The rogue traders are very clever in covering their tracks, making it extremely difficult for us to put together an airtight case against suspects that will convict them in a court of law.”
Enforcer: “I beg to differ. We have known for nearly a decade whom the principle rogue traders are and exactly how they are able to pilfer pennies in huge volume from honest investors day after day. Our people have known for years that the unbridled growth of unregulated HFA trading has created conditions that were ripe for the type of crash that occurred on May 6, 2010 and numerous occasions since then in the trading of individual stocks. It was an accident waiting to happen then and it still is. We believe that traders are using high speed computers and software code to game the market each and every day through market manipulation. One simply has to look at the consecutive string of statistically impossible, profitable trading days to know they are bilking investors. Yet, we are told to stand down. We are told that high frequency trading is off-limits. For Chrissake, we still haven’t banned flash trading, which is the very definition of cheating. No one should be able to see another player’s hand at a polka game. It’s almost like HFA trading is too-big-to-bust.”
Wise Guy: “Listen, these unfounded accusations simply feed into a frenzied paranoia among investors, which itself unsettles the market. High frequency trading provides needed liquidity to our capital markets by narrowing the spread between bid and ask prices. Everyone benefits.”
Enforcer: “Yeah, everyone except honest investors. Any perceived narrowing between bid and ask prices is gobbled up by HFA traders, who can manipulate prices higher or lower at will. Investors pay more for their shares when they buy and get less when they sell. HFA traders bag the difference. It is tantamount to an undeclared tax on each transaction. The so-called liquidity that HFA trading creates is ephemeral and will flee the market in a heartbeat when a trading imbalance is detected. When that happens, the market crashes. It can happen at any time and next time it may not be a temporary phenomenon. HFA traders account for well over half of total market volume. They have effectively cornered the market.”
Wise Guy: “That is sheer alarmist rhetoric and has no place in this discussion. HFA trading has been going on for years and now you are suggesting it is a scam that could trigger a market collapse. We will be run right out of town for gross incompetence.”
Politician: “Gentlemen, can we stay on topic? It would be helpful to shed more light than heat on the matter. The White House is deeply concerned that a market crash, caused or exacerbated by high frequency trading, could occur at any time. Many market analysts are saying it’s just a matter of time. If so, we want to be prepared.”
Lawyer: “That is exactly why we have enlisted the services of Wall Street experts to assist us in our investigation. After all, who is better equipped to explain the intricacies of high frequency trading and how it reacts under such conditions?”
Wise Guy: “Excellent move.”
Enforcer: “So let me understand this. We are going to have the fox help us investigate how he got into the hen house? The SEC is perfectly capable of monitoring and analyzing trading patterns, which would tell us exactly what occurred and why it occurred. It would be easy for us to prove that certain firms are using algorithms to manipulate the markets unfairly to their advantage. We already know that this type of activity makes our capital markets vulnerable to a crash during a trading imbalance or dislocation. The integrity of the marketplace is at stake. If we have to, we can ban or, as a minimum, curtail HFA trading before it too late.”
Wise Guy: “That kind of talk is irresponsible. It sounds like you have made up your mind without one shred of evidence of any wrongdoing.”
Politician: “I agree. We need a plan of action from the SEC that addresses this issue in a responsible manner and we need it as soon as possible. It is perfectly reasonable to have Wall Street experts assist in the investigation because they can offer the resources and expertise that we lack, especially as it relates to such complicated trading activities. When can we expect a draft report on this matter?”
Lawyer: “It will take a few months. In the interim, the SEC feels comfortable that the circuit breakers, which we implemented after the crash of 2010, should be sufficient to mitigate and limit any exposure to another flash crash, if one should recur. After our preliminary report is delivered, we will convene an ad hoc committee to address any new regulatory measures that are recommended, assuming there are any.”
Enforcer: “We’ve been down this road before and result is always the same. High speed traders keep feasting on honest investors, who keep getting scalped.”
Wise Guy: “What are you talking about? The stock market is busy making new highs. Investors are making money. If it ain’t broke, why fix it?”
Politician: “On that reassuring note, this meeting is adjourned. In the meantime, it is business as usual. Frontline enforcers shall take no further action on this issue until we receive the report and review its recommendations.”
Such is life at the SEC. The delicate matter is left in the capable hands of a politician, a lawyer, and a wise guy, all of whom represent the interests of Wall Street. The enforcer is told to back down because he is not a team player. He doesn’t understand that wise guys always win. He also doesn’t understand that the SEC makes believe it regulates Wall Street and that Wall Street, in turn, makes believe it is regulated.