The Case for High-Information Trading

The SEC can help level the playing field by letting companies release more details about their operations in real time.
L. Gordon Crovitz
Wall Street Journal
April 6, 2014
Link to Original Article

Regulators have worked themselves into a frenzy against high-frequency traders, with investigations by federal prosecutors, the FBI, the Securities and Exchange Commission, the Commodity Futures Trading Commission and New York state's attorney general. They may not realize they're investigating themselves. Superfast trading was mandated by regulations less than a decade ago.

High-frequency trading is in the news thanks to Michael Lewis, whose new book, "Flash Boys," is a rollicking account of the colorful characters who spent the past few years building new digital exchanges. Entrepreneurs raised funds to lay fiber-optic cable in lines as straight as possible to maximize transaction speed between Chicago's futures markets and New York's equities exchanges. They locate their computers to be near servers in stock exchanges for "low latency" trading. Silicon Valley-smart developers write the trading software.

It all happened because the SEC issued a rule called Regulation National Market System in 2005. The idea was to lower trading costs through digital trading. But instead of allowing high-tech trading to develop under rules worked out between exchanges and traders—a voluntary system in place since the 1792 Buttonwood Agreement led to the New York Stock Exchange—SEC regulators decided they knew best. They did away with the long-standing practice of aiming for the "best execution" of a trade with a new rule mandating the "best price." Because of technological advances, this best price became determined by digital trading platforms competing over milliseconds.

"Reg NMS was intended to create equality of opportunity in the U.S. stock market," Mr. Lewis writes. "Instead it institutionalized a more pernicious inequality," favoring "a small class of insiders with the resources to create speed."

There are now dozens of public electronic exchanges. The benefits have included lower commission costs for trades and access for all investors to more-accurate prices as the bid-ask spread narrowed.

Mr. Lewis claims, however, that these exchanges are "rigged." He describes how algorithm-driven real-time trading enables front running, in which the trading platform has information about a customer order and acts on it before completing the trade. That would be unlawful whether done online or otherwise.

A pair of SEC commissioners foresaw these unintended consequences. Cynthia Glassman and Paul Atkins dissented from Regulation NMS: "We believe the wiser and more practical approach to improving the efficiency of U.S. markets for all investors would have been to improve access to quotations, enhance connectivity among markets and market participants, clarify the broker's duty of best execution, and reduce barriers to competition," they wrote in 2005. That would have avoided "exposing our markets to unforeseen consequences, redundant regulatory oversight and the concomitant compliance costs that will ultimately be borne by investors."

Now regulators claim the system they mandated creates "inappropriate information advantages" and even "insider trading 2.0." Instead of issuing yet more rules, however, regulators should consult another recent book, a policy-focused companion to "Flash Boys."

In "Knowledge and Power" (2013), technology guru George Gilder asks: "Why in the midst of an information age, when capital and data zip around the planet at the speed of light, do markets reach peaks of volatility resembling tulip auctions in 1690, when carrier pigeons were the fastest transmitters of information?"

His answer is the "outsider trading scandal" the SEC created by limiting the release of material information such as sales, product test results and the successes and failures of new technologies. Its regulations are imposed in the name of a level-playing field, "but a level playing field means no information, since information is inherently unleveling," Mr. Gilder writes. "U.S. securities law manages to reduce the amount of real information in stock prices," increasing volatility and empowering outsiders such as trading exchanges.

Real reform would allow full information about company performance to be reflected in prices in real time, just as trading now happens in real time. Information should be liberated from heavily lawyered news releases and quarterly earnings statements. "Information wants to spread freely," Mr. Gilder argues, "and the more information that is incorporated in stock prices, the more robust the market can be and the less subject to manipulations, euphoria, and panic."

The issue is not whether high-frequency trading should somehow become low-frequency trading. It's unrealistic to try to slow down digital trading. The opportunity instead is to have more high-information trading, with prices determined by market fundamentals, not by the highest-speed technology.