Are High Frequency Traders Playing Fast and Loose With the Rules?

By: Ifrah Law

When high frequency trading (HFT) first crept into the public consciousness, it related to primarily to the question of whether rapid, computer driven trading posed risks to the safety and stability of the trading markets.  Now it appears that HFT may have also been a means for some traders to gain a possible illegal advantage.

High frequency trading involves the use of sophisticated technological tools and computer algorithms to rapidly trade securities.  High frequency traders use powerful computing equipment to execute proprietary trading strategies in which they move in and out of positions in seconds or even fractions of a second.  While high frequency traders often capture just a fraction of a cent in profit on each trade, they make up for low margins with enormous volume of trades.

High frequency trading is viewed by many as particularly risky.  While some participants disagree, the Securities and Exchange Commission and the Commodity Futures Trading Commission issued a report in which their staffs concluded that algorithmic and high frequency trading contributed to the volatility that led to the May 6, 2010 “flash crash.” 

More recently, high frequency trading has come under scrutiny by law enforcement.  A number of agencies are investigating such practices to determine whether high frequency traders are profiting at the expense of ordinary investors.  The Justice Department and the FBI have recently announced investigations, while U.S. securities regulators and the New York Attorney General have said that they have ongoing investigations.

Heightening the recent HFT craze is renowned author Michael Lewis, who recently authored Flash Boys:   A Wall Street Revolt. In the book, Lewis claims that computer-driven stock trading has taken over the market at the expense of ‘the little guy’. According to Lewis, Wall Street is rigged by a combination of insiders – stock exchanges, big Wall Street banks and HFT. Lewis claims that HFT’s advantage is so severe that traders are able to predict which stock a common investor wants to buy before he or she can buy it, and drive the price up before the investor can initiate the purchase.

Not everyone is buying the claims Lewis makes in his book.  There have been many on record stating that HFT actually does not prey on mom and pop investors. Additionally, many individualsbelieve Lewis’ claims are overblown and that HFT does not provide traders with a huge profitable advantage.

Inevitably, the most pressing question about high frequency trading is whether any such businesses are given an unfair – and illegal – advantage in placing trades.  On April 11, three futures traders filed a federal class action lawsuit against CME Group, the owner of the Chicago Mercantile Exchange and the Chicago Board of Trade, claiming that high frequency traders are given an improper advance look at price and market data that permits them to execute trades using the data before other market participants.  While the plaintiffs claim that this practice has existed since 2007, CME denies the merits of the allegations.

Between the investigations and this lawsuit (and the others that will certainly follow), it will eventually be determined whether traders with high speed computers benefited improperly over other market participants.  Regardless of the merits of these accusations, it is unquestionable that high frequency trading, like all technological advances, poses special challenges to existing rules and laws that will require special consideration and possibly require new rules and regulations.