The Glacial Response of the S.E.C. to the Rise of High-Speed Trading and Market Volatility

For those who want the Securities and Exchange Commission to fulfill its mission of protecting investors, the New Year brings more bleak reality. It's bad enough that the Justice Department never indicted a single Wall Street executive for the fraud associated with the financial crisis, leaving it to the S.E.C. to wrist-slap a few financiers. Now, after a year in which the Dow Jones Industrial Average gyrated drunkenly, it's obvious where lax enforcement is taking us.

During the last five months of 2011, the average difference between the Dow's intraday high and low was a stomach-churning 260 points. New research suggests that high frequency trading (HFT), which accounts for about 60 percent of daily U.S. stock-trading volume, exacerbates volatility. Jim McCaughan, CEO of Principal Global Investors, agrees. But whatever the causes of the Dow's daily rollercoaster ride, millions of Americans are getting off it. Ordinary investors withdrew more than $135 billion from domestic stock mutual funds in 2011.

We need ordinary investors -- and their capital -- back in the market. To fuel economic growth and to generate greater returns for investors themselves, whose future retirement income will be lower because their nest eggs are now invested in CDs (which pay negligible returns but are safe) instead of equities (which can pay considerably higher returns but right now are too scary).

In October 2009, Senator Ted Kaufman (D-DE), then almost a lone voice on emerging equity-market instability, and I met with SEC Chairman Mary Schapiro. Kaufman wanted to discuss the explosive rise of HFT and the proliferation of electronic trading venues. (In only a few years time, we'd gone from a duopoly of the New York Stock Exchange and Nasdaq to more than 60 market centers.)

Two problems already were evident. First, in the name of competition, the SEC had created conditions under which trading venues were catering to HFT to the detriment of long-term investors and market stability. The threat to stability became disturbingly apparent on May 6, 2010, when the Dow dropped a thousand points in minutes. Eight months earlier, Kaufman had given a speech in which he predicted just such an HFT-fueled flash crash.

Second, while markets proliferated and HFT went viral, the S.E.C. did nothing to update its surveillance and monitoring capabilities. A blind S.E.C. left investors susceptible to possibly rampant manipulation and illicit trading practices. HFT, Kaufman believed, urgently needed transparency and regulatory oversight. He was concerned the SEC would dither. He told Schapiro, "I don't believe you're going to do anything about HFT." She replied, "Just watch."

We did. Occasionally we'd see something. But progress has been painfully slow (the "C" in S.E.C. doesn't stand for the speed of light). Today, it's not just Senators complaining, but some of our leading investment advisors and commentators. Michael Price, formerly CEO and President of Franklin Mutual Advisors, in a December 2011
blamed the S.E.C. for markets that he says have hurt mutual funds and other traditional, long-only investors. Last week, Gillian Tett of
Financial Times
wrote the next "flash crash" may hit with a

In response to Kaufman, Schapiro wrote back on December 3, 2009, promising action on three fronts. On November 3, 2010, the S.E.C. finalized a rule that prevents HF traders from having unsupervised access (known in the industry as "naked access") to trading venues and requiring brokers to implement pre-trade risk controls on HFT activity on a market-wide basis. On July 27, 2011, the S.E.C. finalized a rule that requires brokers to collect data of large HF traders, which (when implemented in April 2012) will finally provide the S.E.C. with baseline information about how HF traders operate.

Finally, in early December 2011, Chairman Schapiro said she's "very anxious" to require a "consolidated audit trail" for all HFT. This rule, which she implied might be finalized in the coming weeks, would fill the gaps in reporting requirements that prevent the efficient tracking and policing of orders and trades. A consolidated audit trail would give the S.E.C. eyes. Without it, the S.E.C. can't see what's happening and so can't stop manipulative trading strategies, detect disruptive rogue algorithms, or reduce excessive volatility. Let's hope the S.E.C. implements the consolidated-audit-trail rule swiftly.

Monitoring HFT to detect wrongdoing is crucial. But for this New Year, the S.E.C. should resolve to go even further by completing its market structure review and proposing additional reforms. It can start by rereading the 14 recommendations of the Joint Advisory Committee it convened with Commodities Futures Trading Commission after the flash crash (and Kaufman's August 2010 letter containing his recommendations). Unless the S.E.C. acts soon to regulate HFT effectively and prevent the next flash crash, how many more ordinary investors will have fled the market by the next New Year?