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High-Frequency Trading Is Making a Joke of the Markets

Yahoo! Finance
The Exchange

By Jon Najarian

"The secret of life is honesty and fair dealing. If you can fake that, you've got it made!" –Groucho Marx

I suspect the SEC, FINRA, and CFTC are big fans of Groucho Marx, or at least his observations on fair dealing. How else could they justify turning a blind eye to a global media powerhouse such as Reuters selling early access to market-moving information? How could these authorities not condemn a practice like high-frequency trading (HFT), which causes significant market disruptions on a daily basis and destroys investor confidence?

Why would agencies that are charged with oversight of the most robust capital markets in the world choose to disregard their fiduciary duty? My guess is, as usual, it all comes back to money.
But before I get too far ahead of myself, let me briefly explain what HFT is and why someone getting an early peek at information makes a complete joke of fair markets.

Speed matters

Anyone who has traded in any listed product — whether Apple (AAPL) or IBM (IBM), gold or corn, or options on virtually any asset — knows the speed of trading grows faster than the federal deficit. A vast majority of trades of stocks, options and futures are entered electronically, responded to electronically and completed electronically.

This has eliminated the need for the runners who would literally transport the buy or sell order from the desk of the brokerage house to the trading pit, as well as key punchers who filled in the contra-party information, clearing firm, time of execution, and filled price, as well as a host of other jobs. I could wax nostalgic about the good old days, but we all knew then that technology would eventually replace human intervention, order input and trade processing.

In addition, as exchanges were transformed from member-owned/operated not-for-profit entities to for-profit, publicly traded companies, volume of trade became a top priority. Before that switch, the top priority of stock and futures exchanges was maintaining a "fair and orderly market." This change in priorities opened the door for HFTs to quietly enter the markets. Exchanges began to cater to systems that would rapidly enter buy and sell orders much faster than humanly possible. Soon the exchanges began to offer co-located space for the HFT servers right next to their data centers.

A built-in advantage

This gave the HFTs a significant edge, and they were quick to exploit that advantage as they began handling the majority of volume in stock, options and futures. And as their volumes grew, the exchanges bent the rules all the more to accommodate the HFTs. But it was not just the volume of trade that surged; it was also their volume of quotes, electronic bids, offers and cancellations that stressed the exchange's ability to disseminate information.

Knowingly or not, the HFTs had discovered their quotes could blind other investors to the true market price, and this soon became one of their biggest weapons against the investing public. HFT firms could afford 10-gigabyte pipelines, microwave-transmission towers, even tunneling through Pennsylvania Mountains to ensure they could be the first to see and react to the "real" price of assets they were trading. The rest of us were left to trade on the equivalent of yesterday's prices, as the HFTs' nanosecond trading made a full second seem like a full day's advantage!

Regulators need to do their jobs

We all understand why U.S. exchanges (the majority of which are now for profit and publicly traded) would be so accommodative to HFTs, but that doesn't give the SEC, FINRA or CFTC an excuse to abdicate their oversight responsibilities. Co-location of servers is already enough of an advantage to HFTs, but letting them flood the pipeline with quote traffic — a majority of which is not bids and offers but cancel orders — is simply ludicrous.

Moreover, beyond blinding investors with this technological smokescreen, the HFTs cause exchanges to upgrade their pipes that transmit market data far more rapidly than would otherwise be needed. That, in turn, increases costs to all those who want live quotes, further extending the HFTs' advantage.

Fortunately, my friends, not all is lost. The folks at FINRA and several stock-exchange regulators fined Newedge USA $9.5 million for lax oversight of the trading firms from 2008 to late 2011. It seems the slumbering regulators are finally stepping up scrutiny of computer-driven trading, which, as I've said for years, poses risks to the markets and destroys investor faith.

Selling access

Recently my CNBC colleague Eamon Javers broke news that Reuters had been selling early access to the University of Michigan's consumer-sentiment report, and his investigative reporting really shed some light on this despicable practice. For a rumored $20,000 per month, an HFT firm could buy access to data that would be released to the rest of the world two seconds later. Eamon, with the help of my friend Eric Hunsader of Nanex, a firm that tracks high-frequency trading and its impact on our financial markets, proved that the HFTs profited mightily from this early look at the market-moving data.

When called out on live television about this practice, neither the University of Michigan nor Reuters said they saw anything wrong with letting a very small number of market participants have access to the reports ahead of the rest of us. I was shocked, and said both institutions brought shame on themselves by perpetrating this scam, but the SEC, FINRA and CFTC refused to comment.

Then New York Attorney General Eric Schneiderman forced Thomson Reuters to suspend its practice of "tiered release" of market-moving data early to paying clients. Javers said the investigation "will follow all logical leads beyond Thomson Reuters." In a statement, Thomson Reuters said it was cooperating with Schneiderman's investigation and that its decision to stop the early release came voluntarily but "at the request of the attorney general."

I applaud the move by the New York AG, as I saw him fighting against corporate greed for the good of our capital markets and the little guy/gal. "Promoting fairness and avoiding distortions in the securities markets is an important focus of this office," Schneiderman said. "The securities markets should be a level playing field for all investors and the early release of market-moving survey data undermines fair play in the markets."

Amen, Mr. Schneiderman!

I hope that Supreme Court Justice Louis Brandeis was right about sunlight being the best disinfectant. I believe the more investors hear about manipulation by HFTs and so-called tiered releases of important data, the sooner we can fix these distortions before they wreck our markets.

As former Sen. Alan Simpson famously said: "If you have integrity, nothing else matters. If you don't have integrity, then nothing else matters."

Najarian is the co-founder of optionMONSTER, which occasionally competes with Thomson Reuters in providing real-time market information.