Wall St. Regulation in the Digital Age

Posted on September 13, 2011 by in Economic News, Regulation, Wall St.

A new type of regulation is gathering steam on Wall St., and it’s bound to alarm the computer-happy traders who have come to dominate the securities industry.  Regulators are asking Wall Street firms to hand over the proprietary algorithms they use to make speedy, high-volume deals each day.

The Securities and Exchange Commission wants the information as part of its eternal quest to ensure compliance, it says. And the Financial Industry Regulatory Authority (FINRA), perhaps trying to outdo its sometimes-competitor, is pursuing its own investigation of what it calls “suspicious market activity.”

But these computer codes depend on hundreds of hours of research and calculations, and are considered a “special sauce” that firms aren’t eager to share, as a recent Reuters report explained.

By the time the market experienced the flash crash of May 6, 2010, wherein runaway computer trades drove the Dow Jones Industrial Average down by 1,000 points in just minutes, some investors had already begun to worry about the consequences of high-frequency trading. High-frequency trading is a type of algorithmic trading often used to exploit price differentials in global markets. By buying and selling huge volumes at lightning speeds, traders turn small differentials into huge profits.

Observe the crash here:

 

The first investigations into these trades began soon after that startling wake-up call, but so far regulators had only dipped a proverbial toe into the sea of high frequency trading. Now they’re diving in.

Concerns over high frequency trading aren’t limited to potential repeats of the flash crash. In fact, that’s already been somewhat guarded against. Instead, some think that high-frequency trading, even when done right, is bad for the market.

Computers can’t consider nuances like recent changes in company management or complex historic trends, and so any algorithmic trading allocates capital less wisely than a human trader would, opponents say. That in turn does an injustice to the market by wasting capital on investments that are less than ideal. A survey by Liquidnet found that investors are “clearly concerned that their long-term investment styles are at odds with the speculative, nano-second profit taking approach utilized by high frequency traders.”

And the proliferation of warp-speed, automated trading certainly handicaps independent investors. As this piece on 24/7 Wall St. notes, the strategy “excludes Joe Public, leaving the typical investor at a huge disadvantage against the professionals.”