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CORRECTED-INSIGHT-UPDATE 2-Chicago Fed warned on high-frequency trading

(Corrects 23rd graph to clarify Chicago Fed letter was not a direct response to an SEC request for comment on its Jan. 2010 concept release.)

* Chicago Fed warned of need for "kill switch" in 2010 * SEC can't impose limits on HFT without consensus-official * Some traders are trying to build HFT-free trading zone * Retail investors looking for SEC to lead on HFT reform By Emily Flitter and Sarah N. Lynch

NEW YORK/WASHINGTON, Sept 30 (Reuters) - More than two years ago, the Federal Reserve Bank of Chicago was pushing the U.S. Securities and Exchange Commission to get serious about the dangers of super-fast computer-driven trading. Only now is the SEC getting around to taking a closer look at some of those issues.

Critics of the SEC say the delay is part of a pattern of inaction in dealing with the fallout from high-frequency trading and shows that the regulator does not yet fully appreciate how fears of machine-driven market meltdowns are driving investors away from U.S. markets.

Even as the SEC gears up for a meeting on Tuesday to discuss software glitches and how to tame rapid-fire trading, the eighth public forum it has had in two years on market structure issues, regulators in Canada, Australia and Germany are moving ahead with plans to introduce speed limits to safeguard markets from the machines.

One item up for discussion is whether regulators should require trading firms and exchanges to deploy a "kill switch" so that they can quickly shut down a runaway high-speed computer program. That is one of the seven recommendations the Chicago Fed made to the SEC in its March 25, 2010, letter.

The Chicago Fed said exchanges and other trading platforms should install more risk controls, even if it slowed down trading, including a "kill switch" at the trader workstation level. "The competitive quest for greater and greater speed must be balanced with appropriate risk controls so that a clearly erroneous trade does not destabilize markets by precipitating a cascade of other trades in response," the Chicago Fed's then-Financial Markets Group senior vice president, David Marshall, said in the submission.

Less than two months later, the Dow Jones Industrials would plunge 700 points in a matter of seconds. The May 6, 2010, flash crash sparked a national debate over the merits of stock trading that takes place in fractions of a second, but it led to only modest action from the regulators.

Since then, there have been a series of smaller - though still frightening - events for investors, including the near-collapse of major market maker Knight Capital after a software glitch led to violent price swings in more than 100 stocks on Aug. 1 this year. That problem lasted for at least half an hour, leading to questions about why a "kill switch" was not quickly employed.

And still the move toward reforms has been slow.

"So far, the SEC hasn't seemed to think high-frequency trading is a problem," said Edward Kim, a former senior vice president at the NASDAQ Stock Market and now a consultant with audit firm Grant Thornton.

INVESTORS FRUSTRATED

Kim, who testified on Sept. 7 before an SEC panel in San Francisco on the potential pitfalls of high-frequency trading, said he has seen first-hand the fallout caused by the flash crash on investor confidence. Kim noted his father was so rattled by the rapid market meltdown that he subsequently sold most of his stocks.

Institutional buy-and-hold investors also remain frustrated.

Mutual fund manager O. Mason Hawkins, who met with the SEC a month after the flash crash in June 2010 to provide evidence about how rapid-fire machine trading was destabilizing the market, has the same view today, according to a representative for his firm, Southeastern Asset Management.

Even proponents of algorithmic trading, which uses computer model-based probability theories and analysis of market data to formulate trading strategies and execute them automatically, are coming out and saying speed is not everything.

High-frequency trading effectively treats orders from retail investors like a tip sheet to be harvested and discarded, said Andrew Van Hise, managing director at the investment management firm SEQA Capital Advisors in New York and the designer of the algorithmic trading program for Steven A. Cohen's $14 billion SAC Capital Advisors hedge fund.

"By the time a standard retail or institutional order reaches an exchange, it's been looked at in essence by a number of algorithms which have cherry picked it," said Van Hise. "What finds its way to the traditional exchanges is viewed by market participants as exhaust."

To be sure, it is not as if the SEC has simply stood idly by and allowed the machines to run amok. The agency did put in place some new safeguards such as circuit breakers on stocks, after the May 2010 flash crash.

The circuit breakers are intended to prevent a market-wide crash by briefly halting trading in particular stocks displaying sharp price moves within a 5-minute window, giving the algorithms a chance to let go of trading patterns that may have turned into vicious cycles.

In a move that some say is long overdue, the SEC has begun setting up a new analytical and research team to examine the trading patterns of high-frequency firms. The new group, which will receive and process the same data feeds that high frequency traders get, will enable the SEC to better police the markets.

And recently, the SEC fined the New York Stock Exchange's operator, NYSE Euronext , $5 million for allegedly giving some customers "an improper head start" on proprietary trading information.

FINE-TUNING

But U.S. securities regulators, noting that high-frequency trading has brought trading costs down for many investors by pumping more liquidity into the system, do not seem to be operating under any sense of urgency.

"We are into a space now where there aren't any massive changes to be made," said Daniel Gallagher, a Republican commissioner at the SEC who also previously worked in its Trading and Markets division. "There are fine-tuning and dials,"

In January 2010, the SEC published a 74-page "concept release" on restructuring the markets, in part because of the rise of high-frequency trading. The SEC uses concept releases as a blueprint for future regulation. The concept release included ideas like a "trade-at" rule, which would give preference to the price in a proposed trade rather than to its position in the queue, as well as limitations on when high-frequency traders could suddenly pull out of the market.

The proposal generated more than 200 comments, including many from money managers complaining that high-frequency trading was making stock trading more volatile. The agency said it was taking steps to address potential problems with high frequency trading well before the Chic ago Fed subm itted its letter, which was in response to a separate SEC proposal that put some controls on market access. But the concept release, whic h the Chicago Fed also referenced, has no t given rise to much new regulation.

Gregg Berman, who is one of the SEC's leading experts on stock market structure, said regulators found most of the complaints from the public and money managers about high-frequency trading to be anecdotal.

"I've heard many suggestions for how we might slow down the markets. But I think some ideas have ignored the fact that we have markets in which investors demand the ability to trade on an immediate and continuous basis, not at discrete intervals," said Berman.

He continued: "It's like saying 'let's use the rules of train travel, in which every train is on a specific track, to try to dictate how cars should behave, even though cars can drive between the lanes and on the shoulder.'"

A more aggressive approach by the SEC on high-frequency trading cannot come soon enough for those who say the SEC's inaction is hurting both Main Street and Wall Street. They note that even as the Dow Jones industrial average creeps closer to its all-time high of 14,000, trading volumes remain near the low levels reached as the financial crisis began to hit in 2007-2008.

Retail investors have withdrawn more than $313 billion from the U.S. stock market since 2008, meaning ordinary investors have not participated broadly in the market recovery. Some market experts attribute fear of another flash crash, and concerns that the playing field is far from level, for making investors wary of stocks.

RAGE AGAINST THE MACHINE

A few enterprising high-frequency trading pioneers are taking matters into their own hands by designing new trading platforms that are being billed as trading zones that are protected from high-frequency programs. But that could lead to further fragmentation of the market, given that U.S. stocks are now traded on a myriad of exchanges and electronic platforms.

Keith Ross Jr., a former chief executive officer of GETCO, one of the largest high-frequency firms, is now running a trading platform that bills itself as one that is not subject to abusive trading by high-frequency firms.

Ross' company, PDQ ATS, processes orders by imposing a 20 millisecond delay on them and then holding an auction. The delay may not seem like much, but it is enough to deter high-frequency traders from jumping in front of other traders, or trying to influence trading by flooding the market with bids and offers for stocks they do not actually intend to trade.

PDQ, which launched in 2008, is gaining traction with both asset managers and high-frequency firms that Ross says are willing to play by the rules and still see room to make a profit. But the new platform is small, processing just under 100 million shares of marketable orders a day, 30 percent of which get filled.

"My expectation and my hope would be that the market has an opportunity to solve the problem itself," Ross said.

Similarly, Bradley Katsuyama, a former top trader in the United States for RBC Capital Markets, recently left the bank to launch an exchange he says will employ a strategy to prevent high-frequency trading firms from gaining an unfair advantage over mutual funds and other retail investors. He declined to provide specifics of his start-up firm, IEX Group Inc.

Still, plenty of individual investors are looking for the SEC to do something more.

One of those is Jim Sutton, who has been managing his own pension payout for the past 12 years. The 69-year-old Des Moines, Iowa, resident wrote a letter to the SEC on July 4, asking for a new rule that would slow down trading in the stock market to keep it within the realms of human perception.

He said slowing down the markets, just a bit, would improve investor confidence. Sutton says he is still waiting for a response from the regulator.

(Reporting by Emily Flitter and Sarah N. Lynch, additional reporting by Aruna Viswanatha; editing by Matthew Goldstein, Jennifer Ablan and Martin Howell)

((Emily.Flitter@thomsonreuters.com)(+1-646-223-6310, Reuters Messaging: emily.flitter.reuters.com@reuters.net))

Keywords: MARKETS TECH/BREAKDOWNS (