Regulation of HFT

This week, I'm going to focus on the regulatory side of Wall Street. Especially in recent years since the Great Recession, there has been much debate about the extent to which the government should be involved in regulating the stock market. The U.S. Securities and Exchange Commission (SEC) is the entity responsible for handling this.

In July 2010, after much debate in the House and Senate, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed and put into law. This was in effect the first regulatory law on the stock market in decades, and brought about the most significant changes to the financial services industry since the regulatory reform that followed the Great Depression in the 1930s.

The aim of the act was:

"To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes."

Dodd-Frank consolidated regulatory agencies to streamline the regulatory process and increased oversight of specific institutions regarded as higher-risk. It also included consumer protection reforms to increase investor protection. Additionally, it provided tools for financial crises so that another crisis or "bail outs" won't happen again. However, as with all laws, it still has many opponents who either believe the law was not enough to prevent another crisis or that it went too far and unduly restricted financial institutions.

What about High Frequency Traders (HFTs)?

Countries in Europe like Germany and France have already implemented their own regulatory laws on HFTs. In Germany, a new law was passed this September that affects anyone trading in Germany, regardless of origin. The law requires traders to register first with Germany's Federal Financial Supervisory Authority, collects fees from those who use HFTs excessively, and forces markets to install "circuit breakers" that can interrupt trading if a problem is detected. Most importantly, the new law grants the regulator the power to make firms detail their trading practices. What to take from all of this: Germany isn't taking any risks, and no data is private anymore.

No laws of this sort has been passed in the U.S. yet. However, there is plenty of discussion and debate about it due to highly publicized incidents like the Flash Crash and Knight Capital crash, two events I covered earlier in this blog.

The SEC, highly criticized for not knowing enough about HFT to regulate it, is starting to play catch-up. They have started initiatives that will increase the amount of data received from trading exchanges and to record orders from their origination to execution. An office of analytics and research is planned.

A mechanism known as the consolidated audit trail will track all order and trading information as it is passed between brokers and private dark pools before they're compiled or canceled. Information like this has never been compiled before. The SEC also acquired a HFT firm, Tradeworx Inc., to help it develop it's data analytics system (dubbed "Midas", short for Market Information Data Analytics System). Midas will collect trading data that trading exchanges provide to the HFTs who want information milliseconds before the public.

Hopefully, all of this will glean some more information about how HFTs work and how they are able to affect the market. But there are always pundits who believe regulation by the SEC will only hurt the market. John Steele Gordon of Forbes says that "history shows that the financial industry doesn't need the government to help with reform."

In my opinion, gathering data can only help. The SEC is only trying to do it's job and prevent unfair trading practices as well as another crash. While we may be a few years removed from serious regulation of HFT in the U.S., this is a step in the right direction.

Sources:

[1] Christopher Lawton and Andreas Kissler, "Germany to Tap Brakes on High-Speed Trading", Wall Street Journal, September 26, 2012, http://online.wsj.com/article/SB10000872396390444813104578018292059338944.html

[2] Nina Mehta, "SEC Leads From Behind as High-Frequency Trading Shows Data Gap", Bloomberg, October 1, 2012, http://www.bloomberg.com/news/2012-10-01/sec-leads-from-behind-as-high-frequency-trading-shows-data-gap.html

[3] Nathaniel Popper and Ben Protess, "To Regulate Traders, S.E.C. turns to One of Them", New York Times, October 7, 2012, http://www.nytimes.com/2012/10/08/business/sec-regulators-turn-to-high-speed-trading-firm.html?pagewanted=all

[4] Roger Lowenstein (Op-Ed), "A Speed Limit for the Stock Market", New York Times, October 1, 2012, http://www.nytimes.com/2012/10/02/opinion/putting-the-brakes-on-high-frequency-trading.html

[5] John Steele Gordon (Op-Ed), "Wall Street Can Regulate Itself", Forbes, April 23, 2010, http://www.forbes.com/2010/04/23/wall-street-regulation-financial-reform-opinions-contributors-john-steele-gordon.html

[6] H.R. 4173 (Dodd-Frank Law), January 5, 2010, http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf

[7] Financial Crisis Interactive Timeline, http://www.dems.gov/financial-timeline