Light needs to be shed on trade practices of ‘Flash Boys’

Three years ago, a book called “Flash Boys” by Michael Lewis hit the shelves with great fanfare. It was an expose on the world of high-frequency trading (HFT) and the Wall Street sharpies that had found yet another way to skim riskless profits from public markets.

The book prompted regulators and lawyers to scrutinize the HFT trade and whether the public exchanges themselves were facilitating what amounts to electronic front-running. High-frequency traders would get superior information about orders and trades allowing them to jump in front of other orders, execute trades and pocket the spread between bids and offers, almost risk free. 

{mosads}The claim is that exchanges were enabling critical trading and order data to reach HFT traders a split second faster than other market participants, giving them a profit advantage. Essentially, the claim is that these exchanges and high-frequency traders have a highly symbiotic relationship.

The HFT firms get expedited access and in turn, they run huge volumes of trades through the exchanges. High-frequency traders typically account for more than 50 percent of daily equity volume on U.S. exchanges, according to multiple sources. The book recounted how both parties were fat and happy.

Lawsuits were filed against the exchanges in 2014, and regulators scrambled to assure markets and legislators that the matter was under control. The Securities and Exchange Commission (SEC) assured stakeholders that HFT practices were squarely on their radar.

The SEC had launched its Division of Market Structure Data and Analysis website, and not long after the uproar began, it went so far as to gather trading experts to establish a new Equity Market Structure Advisory Committee (EMSAC) to specifically examine the HFT revelations, among other issues. 

Fast-forward to the Dec. 19 decision by a federal appeals court, which has now reinstated claims against several exchanges including NYSE, NASDAQ, BATS Exchange and the Chicago Board Options Exchange. So far, there have been no denials from any of these organizations on the charges, though previously, they have moved to dismiss the complaint.

The lawsuit claims the exchanges knowingly allowed HFT firms faster access to key trading data, giving them riskless trading advantages, other institutional and retail investors be damned. For their part, the exchanges have argued that the co-location and proprietary data feeds were consistent with SEC regulations.

They also argued that HFT firms have invested heavily in financial technology that gives them the ability to compete for trading volumes, improve liquidity and make markets more efficient for all investors.

Meanwhile, the SEC’s EMSAC has been reviewing the various aspects of HFT trading for nearly three years without much formal action to address possible electronic front-running allegations. One organization, the Modern Markets Initiative, which supports the HFT industry, puts it this way:

“We are no closer to any sort of clear-cut explanation to these queries or to how Lewis’ alleged front-running scheme works in our current market structure. We’ve also received no credible information from other informed market participants, who, with their vast knowledge and experience, should be able back up his assertion that one of the greatest crimes of our time is being committed right under our very noses.”

Whatever the facts, it is hoped the court’s decision to reinstate the case and allow the discovery process to proceed will be illuminating. Whether there are emails and other documents from the exchanges that reveal an intention to give HFT firms an inside advantage, knowing it will disadvantage other investors is an important question.

Paul Smith, president and CEO of the CFA Institute noted that, “These questions need to be answered once and for all. There are too many issues about trust and confidence in our public markets not to put these issues to rest. Fintech is a critical advancement to our industry but not when it is used for electronic market manipulation.”

Kurt Schacht is the managing director of standards & advocacy at the CFA Institute, a global association of investment professionals with more than 145,000 members.