The FBI has made an unusual public plea for help rooting out possible securities violations by high-frequency traders. The FBI doesn’t usually go asking for such help from the financial community. So what’s changed? Well, three things have changed to be precise.
1st Change: Speed
First, the speed and technical nature of today’s high-frequency trading is unlike anything the FBI has ever investigated. Today’s algorithmic traders trade at such incredible speeds that they co-locate their servers closer to the exchanges to save milliseconds to gain an edge. The Federal Bureau of Investigation (FBI), working with the U.S. Commodity Futures Trading Commission (CFTC), Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) are working furiously to understand if this speed advantage violates any rules related to manipulation or front-running.
Is Front-Running Insider Trading?
Buying or selling securities based on material, non-public information is called “insider trading.” Front-running is a more subtle offense. Instead of trading on a company’s secret information, front running is trading on an investor’s strategy – before that investor can do so.
An important difference is that “insiders” trade on a company’s non-public information and those insiders have a duty to the company. Front-runners trade on an investor’s known intention or pending order. But to be illegal, the front-runner must have a duty to the investor.
Front-Running is Not New
In 1790, speculators loitering outside of the original U.S. capital building on Wall Street learned that the U.S. treasury, headed by Alexander Hamilton, intended to pay 100 cents on the dollar to any holder of revolutionary war bonds. Armed with this information, speculators raced to the distant colonies and bought up all the available war bonds at pennies on the dollar because they knew that that the bonds would be redeemed for full value. Revolutionary front-runners!
By the early 1970s multiple stock exchanges were quoting prices on the same securities. The SEC noted that unscrupulous traders were taking advantage of the price differences on the various exchanges. They were, in fact, rushing ahead of their own customers to trade for their own benefit. The result was the creation of the National Market System that would eventually allow investors to see prices on all the exchanges.
By 2005 the rules for disseminating market information were consolidated into Reg NMS – National Market System. Some contend that that system is now antiquated and can’t keep up with today’s automated trading.
2nd Change: Dodd-Frank Whistle-Blower Rules
The second change is the new whistle-blower rules initiated by 2010’s Dodd-Frank Act. Regulatory authorities hope that the enticement of 10-30% of any potential fines collected could bring forward a high-frequency trader who can verify if high frequency traders are just trading smarter and faster or if the speed edge is just a tool that enables the traders to manipulate the markets or front-run their own customers.
To date there have been no major indictments alleging computerized front-running. That may change because of the third change.
3rd Change: Michael Lewis
Michael Lewis is the third change. The hugely successful former investment banker and writer of Hollywood blockbusters like The Blind Side and Moneyball has written an expose on high-frequency trading called The Flash Boys. In it he alleges that the market is essentially rigged and that high-frequency traders are working with the exchanges to create a sort of front-running network. True or not, the book is getting a lot of attention, and attention draws the media, and the media will likely pressure regulators and politicians to act.
At the moment regulators have little to act on, hence the plea for help from the financial community. Will a high-frequency whistle-blower step forward? Will he be on-key or will the whole investigation fall flat?