high frequency trading

Is the SEC protecting high-frequency traders?

March 31, 2014: 3:11 PM ET

Michael Lewis has stirred up the debate about how some traders get an unfair advantage. Eric Hunsader, a longtime high-frequency-trading critic who appears in Lewis's book Flash Boys, says not enough attention is being paid to the role of the SEC.

140304114434-securites-and-exchange-commission-620xaFORTUNE -- Michael Lewis's book Flash Boys, which came out on Monday, is about how some traders are using supercomputers to game the market. Lewis said on 60 Minutes on Sunday that high-frequency traders are driving up the prices that all of us pay for stocks. Eric Hunsader, who runs trading information firm Nanex, has long been a critic of high-frequency trading and is in Lewis's book. Hunsader says he agrees with much of what's in the book, but has been surprised that there hasn't been more immediate criticism for the organization that Hunsader thinks is at the heart of giving high-frequency traders their unfair advantage: the Securities and Exchange Commission.

Fortune: Some people are already criticizing the Michael Lewis book for making the issues around high-frequency trading too simple.

Hunsader: I don't think so. It is pretty black and white what the high-frequency traders are doing. You don't build complex systems and spend billions of dollars if you don't know what is going on. Do you think they don't know where their profits are coming from?

Where are their profits coming from?

Everybody who is trading shares except that guy in a room who is just trading less than 100 shares. But for every large stock trade, high-frequency traders are stepping in and making some money off of it. And that includes the trades that mutual funds do. High-frequency trading has also driven way up the cost of market data, which makes it more expensive to trade and also more expensive for the Securities and Exchange Commission to monitor the market. So it's really costing all of us more.

If it is so black and white, why hasn't the SEC put a stop to high-frequency trading?

It's worse than that. The SEC is not only not putting a stop to high-frequency trading, they are allowing it and promoting it. When Brad Katsuyama [one of the main characters in Lewis's book] took all the information he had to the SEC, their response was that the changes Katsuyama was proposing would hurt high-frequency traders. They were most concerned about that. And that's been my experience as well.

But don't we need high-frequency traders? The more people you have trading in a market the better prices you should get. That adds liquidity and makes it easier and cheaper to trade, right?

No. High-frequency traders are not adding liquidity at all. They are actually pulling liquidity away from the market. That was Brad's experience that Lewis writes about in the book. Every time he hits the button to trade, the liquidity he thought was there disappeared and he had to pay a higher price. A decade ago, the average investor starting paying $8 a trade or whatever to online brokerage firms, and that was well before high-frequency trading. So how has it made things cheaper.

But commissions are just one part of the cost of trading, right?

Spreads [the price difference between buyers and sellers] have gone up too. Spreads were the lowest they have ever been in 2006. And Regulation NMS, which essentially gave the high-frequency traders their advantage, was not put into place until 2007.

What about payment for order flow? When exchanges and brokers pay people to trade rather than charge them. That seems upside down.

I am leaving payment for order flow alone. It allows the high-frequency trading arms of brokerage firms to get a risk-free ride on retail order flow. And that makes me mad, but I can only be made at so many things. And think there is one thing that we have to do first.

What's that?

We have to get the SEC to stop protecting high-frequency trading. The SEC is allowing a system where high-frequency traders are allowed to get the information about trades before the rest of us.

But if they are spending billions to get that info faster, is there a solution?

Yes. Reg NMS was supposed to ensure that every trade no matter what exchange it was executed on always got the best prices. So everyone was just supposed to see the best quotes. Instead, high-frequency traders get to see all the quotes and trades people are entering in the system, and they see all those quotes before anyone else. And I have evidence of this. There is no question this is going on. So we already have the regulations, they just need to be enforced.


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