SEC May Monitor High-Frequency Trading With Consolidated Audit Trail

Powerful computers scan dozens of markets and order millions of stock prices every second. These computers, situated in banks, hedge funds and trading firms around the country, identify small discrepancies in stock prices and trade hundreds or thousands of stocks within milliseconds in order to beat other traders.

This type of trading, called high-frequency trading, accounts for 53 percent of all transactions in the U.S. stock market, up from just 26 percent in 2006, and it has reaped $12.9 billion in profits over the last two years, according to the Tabb Group.

In Washington, D.C., regulators wait weeks to hear back from firms about specific trades. Initially, they do not find out the customer of the trade; they need to follow up with individual trading firms to eventually determine the customer's identity. In some cases, they do not even learn the time of the trade. The SEC cannot be sure that its sequencing of trades is accurate, since clocks across the stock market are not synchronized.

Regulators have struggled over how to best deal with the quickly growing world of high-frequency trading. As computers conduct rapid-fire trades that regulators cannot even sequence in order, traders and investors are able to manipulate the market in ways that regulators cannot identify.

"The traders are driving Ferraris, and the market policemen -- the regulators -- are riding bicycles," said Dan Hubscher, capital markets executive at Progress Software.

As high-speed computers play an increasingly important role in the stock market, the Securities and Exchange Commission (SEC) -- the regulatory agency that is charged with maintaining "fair, orderly, and efficient markets" -- is determined to trade its audit trails for a computer system that can keep up with Wall Street's.

The SEC proposed a rule last year that would create a computer system powerful enough to monitor high-frequency trading, and it plans to release a detailed blueprint in the next few months, according to The Wall Street Journal. The proposed computer system, called the consolidated audit trail (CAT), would examine the transfer of U.S. stocks in real time, and it would identify the customers behind each trade as well as the time that each trade was made, down to the millisecond.

The new computer system would give the SEC more complete information to identify the causes of sudden swings in the stock market and to crack down on regulatory violations, such as market manipulation and insider trading. Without such a computer system, the SEC is largely blind to trades that may be illegal.

"It is like trying to put together a jigsaw puzzle, but only being able to see a small part of the final picture," SEC chair Mary Schapiro said in May of 2010, when the SEC first proposed the rule. She said a consolidated audit trail would allow the SEC to see the full picture, giving them the ability to "rapidly reconstruct trading activity and quickly analyze both suspicious trading behavior and unusual market events."

There are signs that because of its sheer volume, high-frequency trading may sharpen increases or declines in both individual stock prices and the stock market as a whole. Although high-frequency trading does not directly cause market volatility, it can create negative feedback loops that can culminate in a stock market crash, according to a recent U.K. government study cited by Bloomberg News. Since the U.S. stock market is already vulnerable because of the weak economy, the outsize influence of high-frequency trading has the potential to compound the depth of a stock market crash, according to MIT economist Andrew Lo.

High-frequency trading wields a growing amount of influence over the movement of the stock market. The total volume of trading in the U.S. stock market has escalated with the growth of high-frequency trading. The 2.8 billion shares traded every day in the U.S. stock market in 2000 have more than tripled to 8.5 billion shares traded per day in 2010, according to the Tabb Group.

Meanwhile, the SEC has lagged behind. Several market experts pointed to the sudden stock market crash on May 6, 2010, as evidence that U.S. regulators need better equipment to investigate trading and the causes of stock market movements.

On that day, the Dow Jones Industrial Average plunged more than 1,000 points with no major news to account for the panic, then rose again minutes later and closed down 347.80 points for the day. Because of the SEC's limited technology, it took months for the commission to determine the cause of the "flash crash." The SEC finally reported last October that one Kansas firm's $4.1 billion computerized sale on a futures index of the S&P 500 caused the plummet. Subsequently, many firms turned off their high-frequency trading machines, exacerbating the sudden stock market plunge.

As it has become more likely for investors to do business with a machine on the other side of the trade, it has also become more critical for those machines to stay in the stock market in order to keep the stock market afloat. But while high-frequency traders provide more liquidity to the stock market in good economic times, they worsen bad economic times when hedge funds and banks turn off their trading computers for days or even weeks, according to Lo, also a MIT finance professor.

"It's like being on a seesaw and suddenly somebody gets off the seesaw when you're in the air on top," Lo said. "You can fall down pretty hard."

The SEC's inability to determine the exact timing of trades, in relation to that of other trades, blinds it to the source of potentially illegal activity. As stocks trade hands almost instantaneously in today's stock market, insider trading or market manipulation can rapidly shape-shift. One trade can immediately spark other trades. Without the synchronized time stamps of such trades, it is difficult for regulators to find out which one was first.

"In a market where abuses do happen, not doing surveillance in real time is like flashing a red cape at a bull," said Hubscher, a capital markets executive at Progress Software. "With that time lag, you're almost inviting abuse because people could know they're getting away with it."

The customers of such transactions -- rather than the traders themselves -- are sometimes responsible for financial crimes such as insider trading. Regulators are blind to them, too. In their current audit trails, regulators do not find out the customer of trades at all until following up with trading firms about suspicious trades. These customers can conduct trades through various trading firms across different markets, without regulators ever finding out.

"There's no way that the regulators know what's actually happening in these trades," said Ted Kaufman, a former U.S. senator from Delaware who teaches law at Duke University. "Without transparency, you cannot have regulation."

If the SEC does not gain a better grasp on high-frequency trading, the U.S. stock market could be at risk of losing its credibility, Kaufman said. If investors lose confidence in the fairness or stability of U.S. markets, he warned, then investors may leave for other shores.

A consolidated audit trail would aim to address these concerns. Although the SEC has proposed to mandate U.S. stock exchanges and the Financial Industry Regulatory Authority (FINRA) to design the consolidated audit trail, it has also outlined preliminary requirements for the design in its proposal.

For one, the SEC has proposed that each U.S. stock exchange and its members synchronize their clocks, so that the SEC can know the exact time of each trade.

Darrell Duffie, finance professor at Stanford, said under the current system the SEC is likely to recreate an incorrect sequence of trades since the difference between trades often is a matter of milliseconds.

"If you see a trade occurring in one market at 10:59:21 and in another market at 10:59:23, you want to be damn sure that the second trade is indeed after the first one," Duffie said.

The SEC has also proposed that stock exchanges and FINRA provide detailed, real-time information about each stock price order and trade, and that they assign special identifiers to every stock order and customer so the SEC can track them. That way, the SEC would have access to a comprehensive database of trades in the U.S. stock market that regulators would be able to analyze more quickly.

In order for regulators to be able to influence trading in real time, the SEC is considering the possibility of developing automatic surveillance of the stock market that would alert both the trader and the SEC to trading activity that appears illegal, according to an SEC official who requested anonymity. Then, hopefully, the trader would "immediately" stop the illegal activity, allowing the market to self-correct quickly, the SEC official said.

The SEC currently estimates that the consolidated audit trail will cost $4 billion, and since Congress has restricted new funding for the SEC, it has asked FINRA and stock exchanges to come up with the money themselves. It is possible that FINRA and the stock exchanges could impose a transaction fee on high-frequency trading, or ask all market participants to pay a flat fee in order to come up with the money.

High-frequency traders balk at the idea that the cost could be passed down to them.

"High-frequency traders don't make a meaningful amount of money," said Manoj Narang, founder and chief executive of Tradeworx Inc., a high-frequency trading firm in New Jersey. "If the SEC is insisting that it costs more than $1 billion to do a consolidated audit trail, then all it is doing is engaging in a power grab."

Nonetheless, Narang maintained that he supports "any initiative that allows the regulators to engage in data-driven decision-making."

Jonathan Berk, a Stanford finance professor, pointed out that there other ways that the SEC could improve investing, and at a smaller cost. For example, he said, the SEC could collect corporations' quarterly statements in a searchable database, rather than in PDF files, so that investors "could actually use the data."

But MIT's Lo said that even $4 billion, especially if spread out over a few years, is "quite a bargain."

"Right now, because of the sheer volume of information and the disorganization with which some of that information is being produced and archived, it's actually quite difficult to understand the market exposures that we're facing," Lo said. "This [the consolidated audit trail] is not a cure for stock market crashes, but it will provide us with a great deal more information so we can actually manage through these periods of market turmoil."