NY Attorney General Cracks Down On HFT Exchange Co-Location
Going on six years now, America has been waiting to see if there will be any repercussions for Wall Street banking firms for their role in the global economic crisis. This week, New York Attorney General Eric Schneiderman is expanding efforts to "shine a light on unseemly practices that cater to high frequency traders at the expense of other investors."
Among them is the practice of allowing high frequency traders to co-locate their machinery in the exchanges, giving them a latency advantage over other firms outside those datacenter walls.
At a New York Law School symposium, titled "Insider Trading 2.0 – A New Initiative to Crack Down on Predatory Practices," Schneiderman detailed several of the products and services that high frequency traders use to gain competitive advantage. These include early access to proprietary data feeds, which are faster and more accurate than what is publicly available, as well as co-location practices that allow firms to house their servers inside the exchanges.
"Rather than curbing the worst threats posed by high frequency traders, our markets are becoming too focused on catering to them," said Schneiderman, who took office on January 1, 2011. "I am committed to cracking down on fundamentally unfair – and potentially illegal – arrangements that give elite groups of traders early access to market-moving information at the expense of the rest of the market. We call it Insider Trading 2.0, and it is one of the greatest threats to public confidence in the markets. It's long past time that we focus on structural reforms to help eliminate the unfair advantages enjoyed by high frequency traders."
In high speed trading, competitive advantage is measured in milliseconds. With time on their side, high frequency traders can make rapid and often risk-free trades before the rest of the market can react. This has led Wall Street's most tech-savvy traders to co-locate their computer servers in the same datacenters as the exchanges, a set up that employs ultra-fast connection cables and special high speed switches. The firms pay thousands of dollars each month to NASDAQ and the New York Stock Exchange for the privilege of near-zero latency.
Services that provide extra network bandwidth are the back-bone of HFT, which relies on algorithms, fast computers, and ultra-low latency networks to make rapid buy and sell orders based on momentary differences in stock prices. Unlike traditional long-term investing, the strategy is to hold the position for extremely short periods of time. Each transaction might only make a few pennies, but with the high volume of trades, that can add up to billions of dollars each year. In the United States, it is estimated that over 50 percent of the trade volume is performed in the HFT arena.
Besides giving HFT firms a major latency advantage, the arrangements make it possible for traders to continuously monitor the exchanges for large incoming orders. For example, if a firm can detect a hefty order from an institutional investor, like a pension fund, it can take the opposite position to artificially manipulate the price.
Manoj Narang, CEO of Tradeworx, a high frequency trading company in New Jersey, disagrees with Schneiderman's approach.
"People who take advantage of commercial offerings that are available on a widespread basis aren't breaking any laws," Mr. Narang told the New York Times.
If exchange co-location is taken off the table, it will "set off a far more expensive arms race for physical proximity," said Mr. Narang, as firms scramble to find an alternative location to host their wares. In some ways this could lead to unfairness within the elite HFT space. In the co-lo exchange, the firms are provided with identical links to the main datacenter, with the network cables being measured to the precise inch. If they are forced to move to adjacent blocks, the latency advantage will go to the shop that scores the closest connection.
Critics, though, say high frequency traders are gaming the system. The Attorney General did not mince words when he explained some of the failings of HFT during his speech.
"Unlike the rest of us who invest in the markets, as I hope you all do, some high frequency traders appear to trade with virtually no risk," Schneiderman said, addressing the New York Law School panel. He cited a large high frequency trading shop, Virtu Financial, that made money every single day for six years, except for one day. In contrast, Goldman Sachs, a preeminent Wall Street trading firm, has reported 219 unprofitable trading days over the last five years.
"I do not begrudge anyone their right to make money," Schneiderman went on, "but if something seems to be too good to be true, it usually is. And we question whether there are some traders that are just so smart that they never, ever lose money without some special advantage."
The Attorney General is working on ways to mitigate these advantages. Currently the system is set up to reward speed over price. A proposal from the University of Chicago suggests putting a speed bump in place, such that orders would be processed in batches after short intervals. Even a one second lag would ensure that the price would be the deciding factor in who gets the trade, thus negating much of the advantages of speedy equipment and early access to market data.
According to Schneiderman, this structural reform, sometimes referred to as "frequent batch auctions," would reduce the incentive to implement untested, potentially destabilizing technology and could actually increase liquidity by reducing the costs imposed on all market participants.
Schneiderman's office has met with the New York Stock Exchange and NASDAQ about these issues. His office has also secured interim agreements with a number of prominent financial firms, including Merrill Lynch, Citigroup Global Markets Inc., JP Morgan Securities, Morgan Stanley, and several others, to stop their practice of surveying Wall Street analysts, on the grounds that the practice favors a few clients at the expense of smaller players. The Attorney's office has also secured agreements with wire services Business Wire and Marketwired to stop providing traders with early access to market-moving information. Eliminating that advantage helps restore fairness to the markets, according to Schneiderman.