By Ted J. Krapin
The Federal Bureau of Investigation has joined several authorities, including the U.S. Securities and Exchange Commission, Commodity Futures Trading Commission, and New York State Attorney General Eric Schneiderman, in investigating whether high frequency trading (“HFT”) firms break U.S. laws by acting on private information aggregated by super-fast computers in order to gain an edge over their competitors. The FBI has openly solicited traders and stock-exchange workers to blow the whistle on possible front running and market manipulation by HFT firms. The investigation stems from a multi-year crackdown on insider trading that has resulted in 79 convictions of hedge-fund traders.
HFT firms use super-fast computers and algorithms to trade securities at rates measured in thousandths or even millionths of a second to capture price discrepancies and arbitrage opportunities. HFT accounts for approximately 50% of the U.S. equity trading volume and 40% of equity trades in Europe.
The FBI investigation focuses on whether HFT firms are able to take advantage of sophisticated computers by gathering orders placed by institutional investors moments before the order is filled and using the information to place or cancel orders at a different price. Through HFT, insiders are able to legally front run retail orders by seeing a desire to buy shares, acquiring them in front of investors, and then selling them back at higher prices to achieve immediate profits.
Michael Lewis, one of the most-read authors on Wall Street, examines HFT in his new book, Flash Boys: A Wall Street Revolt. In Flash Boys, Lewis outlines HFT, rationalizes that the market is “rigged” and that everyone who owns equities is victimized, and provides examples to show how lucrative HFT can be. One example is of a technology firm that spent $300 million to build a line that cut three milliseconds off the time it takes to communicate between New Jersey and Chicago, and leased the line out to several securities companies for $10 million each.
Lewis also devotes a portion of Flash Boys to Brad Katsuyama, a former trader for Royal Bank of Canada. In 2008, Katsuyama noticed that every time he tried to purchase a large block of stock for a client, the order would only partially be filled and the price of the stock would increase for subsequent portions of the order.
Katsuyama assembled a team of experts and discovered that the market manipulation was made possible by the way trades were routed through fiber-optic cables in exchanges outside of Manhattan. Katsuyama figured out that he could prevent losses from high frequency trading by sending trades to the farthest possible exchanges. He subsequently developed his own exchange, IEX, now used by a number of major hedge funds and investment banks to thwart the effects of high-speed trading.