SEC Can’t Seem to Get a Handle on Newfangled Computers

Wednesday, September 26, 2012, by Justin Mann

On September 19, Emm Holdings, LLC filed a complaint in the United States District Court for the Eastern District of Wisconsin.  Suing under the Freedom of Information Act, the firm is seeking evidence of the SEC’s inability to regulate the exploding field of “high-frequency trading” (HFT).  HFT consists of a huge number of trades (millions every second) conducted by computers using sophisticated algorithms, written by some of the smartest mathematicians in the country, with little to no human input.  With so many trades being conducted at such fast speeds, problems are bound to come up.  The most recent debacle involved Knight Capital Group’s computers using new software to submit erroneous trades that cost the firm $440 million.  Unfortunately, the SEC’s own chairman has said the agency is “hard-pressed to keep up with the financial industry, especially where technology is involved.”  Commentators have not been as kind, analogizing the SEC to “pitting Barney Fife against Michael Corleone” or the traders driving Ferraris while the SEC is riding a bicycle.  The question then becomes, “What should the SEC be doing?”

 Suing under the Freedom of Information Act, the firm is seeking evidence of the SEC’s inability to regulate the exploding field of “high-frequency trading” (HFT).

One thought is that the SEC should require traders to test software before allowing it to operate in the market.  As it happens, in 1989, the SEC passed the second version of its Automation Review Policy, in which it set out specific recommendations for what firms employing high-frequency trading should do for new and existing software: (1) estimate trade capacity, (2) periodically conduct capacity tests, and (3) have independent software assessments conducted annually.  The problem is the ARP is voluntary.  The good news is that the SEC just recently hinted at strengthening this policy, despite the Government Accountability Office, back in 2004, suggesting stricter software testing like that in ARP.

The pinnacle of the SEC’s behind-the-times technology is its current approach to investigating potential regulatory violations ˗ After sending a request for information to a firm and other sources of data, the SEC can wait weeks to receive it.  Even after receiving the information, they are not seeing all of the orders, and the lack of synchronized times between the 15 exchanges can prevent the SEC from developing a proper sequence of trades.  The SECs $4 billion solution is a consolidated audit trail (CAT) system, which would include all orders from all exchanges tracked in one system, based on one synchronized clock, with real-time monitoring capabilities.  The industry’s problem with this system is that the SEC wants the exchanges to foot the bill, which would likely be passed downstream to traders in the form of order fees.  As others have already suggested per-order fees as a way of deterring high-volume trading, this could be a way for the SEC to limit the profitability of manipulation through HFT, without getting tagged with over regulation or burdens of administration.

Other suggestions for regulating HTF include setting 50 milliseconds as a minimum amount of time between buy and sell orders or automated surveillance that would warn traders of their potentially illegal activity.  Regardless of what the SEC ultimately decides to do, recent events seem to highlight the need for action.