High Frequency Trading Is Not Like a First Class Airline Ticket – Unless You Have Also Hijacked the Plane and Robbed the Passengers in Coach

By Pam Martens: April 29, 2014

Mary Jo White, the Chair of the Securities and Exchange Commission, will appear before the House Financial Services Committee this morning at 10 a.m. to boast about the past year’s accomplishments at the SEC and possibly handle a few queries about the growing public perception that stock markets are rigged. 

White’s appearance before a Congressional panel comes at a time when the SEC is undergoing a serious discrediting of its oversight of Wall Street. Earlier this month, James Kidney, an SEC trial attorney who retired at the end of March, unleashed a firestorm of negative attention on morale inside the SEC. In a March 27 retirement speech, Kidney criticized upper management for policing “the broken windows on the street level” while ignoring the “penthouse floors.” Kidney blamed the demoralization at the agency on its revolving door to Wall Street as the best and brightest “see no place to go in the agency and eventually decide they are just going to get their own ticket to a law firm or corporate job punched.” (Retirement Remarks of SEC Attorney, James Kidney.)

It also does not help White’s credibility that a self-regulatory body overseen by the SEC, the Financial Industry Regulatory Authority (FINRA), has an enforcement chief suffering from foot in mouth disease.

Last week Megan Leonhardt, writing at WealthManagement.com, tipped off the public that J. Bradley Bennett, Executive Vice President of Enforcement at FINRA, suggested that high frequency trading was no different than buying a first class ticket on an airplane. (Both Bradley and White previously worked for big Wall Street go-to law firms: Bradley at Baker Botts, White at Debevoise and Plimpton.)  

What exactly is high frequency trading? As thoroughly detailed in the new Michael Lewis book, “Flash Boys,” and previously detailed in Wall Street Journal reporter Scott Patterson’s book, “Dark Pools,” and exquisitely explained for years by the brilliant Eric Hunsader of Nanex, as well as those courageous fellows, Sal Arnuk and Joseph Saluzzi at Themis Trading, high frequency trading is a rigged game where big money buys computer speed, hires physicists and programmers to design ever more complex algorithms and artificial intelligence programs which then ply their wares on U.S. stock exchanges to loot the pockets of ordinary investors.

Here is what is currently happening every day on Wall Street by high frequency traders. See if any part of this sounds to you like simply buying a first class seat on an airplane:

The New York Stock Exchange and Nasdaq (also supervised by the SEC) are selling the right to high frequency traders to co-locate their high speed computers next to the exchanges’ own computers so high frequency traders can get an early peek at order flow and jump in front of slower traders. The exchanges are also allowing exotic stock order types for high frequency traders which turn the little guy’s orders into sitting duck trades to be fleeced. The big broker dealers on Wall Street are no longer required to subject their stock orders coming from the public to sunshine; they simply match up the buy and sell orders inside their own firms in what are called “dark pools.”

Where the head of enforcement for FINRA sees a first class airline ticket, Senator Ed Markey of Massachusetts sees a Formula-One race car hurtling out of control. In a letter to the SEC on January 18 of last year, Markey said: “Just as we do not allow people to drive a Formula-One race car at 200 MPH on the Massachusetts Turnpike, we should not allow a few Wall Street firms to trade millions of times faster than the average 401K investor on the S&P 500.”

The one thing Senator Markey got wrong in his letter is that it’s no longer “a few.” It’s now a thundering herd of high frequency traders in a vicious high-tech arms race.

At one time, the New York Stock Exchange was the most respected stock exchange in the world. Through lax regulation by the SEC, it’s become a pay-to-play minefield of conflicts. In a Google cache of a promotional piece aimed at high frequency traders, the New York Stock Exchange boasts that it is offering a “fully managed co-location space next to NYSE Euronext’s US trading engines in the new state-of-the-art data center.” The NYSE says it is for “High frequency and proprietary trading firms, hedge funds and others who need high-speed market access for a competitive edge.”

One of the key problems at the SEC in terms of getting its mind around the dangers posed by high frequency traders and making the stock markets fair to average folks may be the background of one of the key men studying the problem at the SEC, Gregg E. Berman, Associate Director of the Office of Analytics and Research in the Division of Trading and Markets.

Berman holds a B.S. in Physics from M.I.T. and a Ph.D. in Physics from Princeton. Prior to joining the SEC, Berman served in various executive positions over 11 years with RiskMetrics Group, a risk modeling firm incubated at JPMorgan in the early 90s and spun off as a separate firm in 1998.

RiskMetrics is acknowledged as the firm that created a highly complex model called Value at Risk, or VaR, which attempts to express how much money a financial institution or trading desk can lose over a set period of time, such as the next 24 hours, week or month.  It was JPMorgan’s VaR models that played a role in the bank losing $6.2 billion of depositors’ money in the London Whale bets on exotic derivatives.

A patent at the U.S. Patent and Trademark Office names Berman and two others as inventors, and RiskMetrics as the assignee. The patent allows hedge funds to keep the actual positions in their portfolio a secret while providing a less than fully transparent risk analysis to investors.

Perhaps what the SEC requires is not a rocket scientist looking at the problem of high frequency trading but someone with the common sense of Ed Markey who can comprehend the pressing need to remove dangerous speeding vehicles from a highway originally created for the safety and fair use of everyone.

The SEC has made no secret of the fact that it plans to study the problem to death rather than risk the ire of the well-financed army of lobbyists for the high frequency traders and dark pools. Congress has been dodging taking action since the Senate Banking Committee hearing on December 18, 2012: “Computerized Trading Venues: What Should the Rules of the Road Be?” With each passing day, confidence in the fairness of U.S. markets becomes ever more difficult to restore.

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