Anthony Malakian: HFT: Enemy of the State

Don’t look now, all you quote stuffers and layer-ers, but the Federal Bureau of Investigation (FBI) might well be interested in you. In March, the Financial Times reported that the FBI joined forces with a new unit in the Securities and Exchange Commission (SEC), which will examine how hedge funds and other firms are using algorithm-based trading strategies.

In December, I spoke with an FBI agent who attended our Waters USA conference in New York. I reached out to her recently for clarification on the FBI’s interest in high-frequency trading (HFT), but did not receive a response. My guess is that the Bureau is in the research phase to be able to wrap its head around the systems that underpin HFT strategies. Why else would the FBI attend an industry conference on technology?

The SEC’s recently formed Quantitative Analytics Unit will look to prevent and prosecute cases of quote stuffing, layering and insider trading.

It’s the last misdemeanor that I find most interesting – this isn’t your Martha Stewart version of insider trading. Rather, they are examining algorithms that scan and aggregate news feeds and social networking sites and, in a fraction of a second, trade on that information. While technically that content is being legally produced and disseminated to investors at the same time, it is, on a practical level, impossible for individual investors to consume that information, understand what it means, and trade on it in less than a second.

“The trades are so quick, often completed before the information is widely disseminated, that authorities are debating whether they violate insider trading rules, people familiar with the matter said,” the FT story reads.

Investors might not always ask the right questions, but at least they are asking questions, which, as a minimum, warrant empirical, quantifiable responses.

Growing Usage
This is an interesting debate. News aggregating algorithms have been growing in usage in recent years as hedge funds have tangled with how best to trade off sites like Twitter or how best to gain an advantage over competitors as they try to beat them to breaking news. They have invested in new algorithms and trading platforms for this purpose, but there’s a worry that they haven’t made similar investments in compliance and risk management solutions.

In theory, any investor can buy these algorithms, so technically they’re publicly available, but if you haven’t got the capital to buy one, stay out of the yard with the big dogs. But that sentiment hardly reflects a safe and equitable way of running a market. And, potentially, according to a policy officer at the European Commission (EC), the new Markets in Financial Instruments Directive (Mifid II) may make it possible for any investor, regardless of their degree of sophistication, to trade algorithmically.

“There’s a general idea that anyone operating an algorithm would have to be a licensed firm, and would have to have the right systems and controls in place,” the EC’s Jasper Jorritsma said at TradeTech Europe last month.

Good luck trying to prescribe what the “right systems and controls” will entail. Also, if algorithmic trading isn’t available to all investors, and algo trading platforms are able to trade on news that, legally, must be disseminated to everyone at the same time, wouldn’t that constitute some form of insider trading, given that in those first precious milliseconds, the machines will be the only ones to process and “understand” the news?

The counter argument is that many trading firms and vendors have invested a good deal of capital into developing these systems and algorithms. And there are academic journals and research that say high-frequency trading brings liquidity into the market.

Maybe we don’t have to get rid of HFT entirely. Some talk of taxes on trades submitted, or penalties on failed/cancelled trades, while others argue that employing a speed limit is the answer.

Here’s why I like the FBI getting involved: It provides the SEC with the needed backing to better regulate the industry. Right now, I don’t know that there’s a proper understanding of how best to deal with HFT. In the interim, it’s a good idea to let potential wrongdoers know that there’s another big dog entering the fray.