High Speed Trading: What Do You Mean Front-Running Investors Isn’t Illegal?

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by LV

In the past few days, an avalanche of interest has been triggered by the introduction of Michael Lewis’s new book, Flash Boys, which sheds light on how high frequency algorithmic traders rip-off honest investors and mutual funds 24/7/365 by stepping in front of their orders to score pennies on their transactions in huge volume.  Mr. Lewis declares that the market is rigged in favor of high speed algo traders who routinely skim millions of dollars in obscene profits each and every trading day, which are statistically impossible unless they are cheating.  His book describes how high speed infrastructure is designed to achieve these remarkable results as firms race to shave microseconds off the time trading data travels between their computers and the market exchanges. Mr. Lewis has managed to roll back the tide to expose the ugly flotsam that infiltrates the plumbing our financial markets.  He shows how high frequency traders siphon money off the top of the market, making boatloads of cash for themselves.

A discordant note is struck, however, when Mr. Lewis and some other market analysts declare that there is nothing illegal going on.  One might ask: how can it be legal for high speed traders to rig the market? It is a contradiction in terms. “Rig” and “Legal” do not go together, no matter how clever an argument to the contrary might be.  Most Americans would accept this view because most Americans are apostles of the obvious. How can market regulators allow computerized front-running to go on for years when it is self-evidently wrong to most rational people?

If it is a crime for wise guys to skim cash off the top of casino proceeds, how can it be any different for high speed traders to do the same in the marketplace?  To continue with the casino analogy, how long would it take a casino operator to bum-rush a patron out the door who is caught peeking at someone else’s poker hand?  Indeed, the players at the table probably wouldn’t wait for the casino operator to intervene and would handle the situation themselves. No one likes a cheater, particularly when they are bilking retirement funds or college funds earmarked for their kids.  And it doesn’t matter whether the amounts being fleeced only involve pennies or nickels on each transaction. They just want the practice stopped and they want it stopped yesterday. They also want the pilfered money returned and the practitioners brought to justice.  If an individual attempts to play the same game in the penny stock market and front-runs retail investors and traders, how long do you think it would take the Securities and Exchange Commission and the U.S. Justice Department to bust him?

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Those who contend that computerized front-running isn’t illegal are probably following the lead of the SEC, which is staffed with scores of attorneys and has access to the opinions of armies of outside legal consultants.  Who can blame them when the SEC, our market watchdog, has shown no inclination to investigate and prosecute practices, which appear to be fraudulent under the provisions (Rule 10b-5) of the 1934 Securities Exchange Act?  It is easy for a layman to mistakenly conclude that the SEC must be correct in its legal interpretation, assuming it has even rendered one.  After all, the SEC should know the rules and the law. Shouldn’t they? On the other hand, it could simply be that the SEC has elected to do nothing, leaving investors to fare for themselves.

The sweeping anti-fraud language of the 1934 Securities Exchange Act states that is unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange “to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”  How is manipulative high-speed computerized front-running not a violation of this long-standing statute?  Certainly, it is does not serve the interest of investors to be front-run by high speed traders. By definition, market manipulation is a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency.  It is difficult to characterize the chiseling of unsuspecting investors through high speed computer algorithms as anything other than chronic manipulative thief at millisecond intervals.

Michael Lewis may be doing himself and his thesis a disservice by expressing a legal opinion that is seemingly at odds with his compelling evidence that the market is rigged.  His legal assertion appears to be wrongheaded and illogical on its face. Most people would reflexively say that high speed front-running is harmful to investors on the other side of the trade and, therefore, must be against the law.  Unless he is absolutely certain of his position, Mr. Lewis should qualify his statement about legality of computerized front-running and simply say it is a matter for the courts to decide. It would be even better to say, if high speed manipulative front-running isn’t illegal for some reason, it should be.  

Please note that none of this discussion should diminish the breakthrough work done by Mr. Lewis to expose fraud in our financial markets and maybe, just maybe, our market regulators will do their job and take action to correct the iniquities.

In the meantime, the SEC can put an end to this scam any time it wants by seriously curtailing or banning high frequency algorithmic trading that puts investors at a decided disadvantage.  Moreover, such trading puts market investors in serious peril. See investmentwatchblog.com/a-market-crash-waiting-to-happen/.  For way too long, the playing field has been tilted big time toward those who have the tools and wherewithal to step in front of the line to make a quick buck each and every trading day.  By sitting on its hands, the SEC has given an aura of legitimacy to a predatory practice that should have been nipped in the bud years ago.

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