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Here's what the SEC needs to do about HFT

Change is often for the greater good. But when one of these good changes is abused, it winds up benefitting a few at the cost of the majority. That's what happened with high-frequency trading.

So, answer to the question, "Should regulators step in on HFT?" is an absolute YES. The more difficult to say is what they should do to curb the bad practices that Michael Lewis profiled in "Flash Boys: A Wall Street Revolt."

NYSE EuroNext flag hangs outside the NYSE.
Adam Jeffery | CNBC
NYSE EuroNext flag hangs outside the NYSE.

First, a little bit of my background in the field of HFT. With my partner Chris Keith, the former head of technology of the NYSE, we developed an instant auction system for stocks that we called Financial Auction Network (FAN). Little did I know in 1994 that if we had focused on instant auctions for airfares and hotel rooms, we could have been multi-billionaires! Instead, we focused on applying it to trading stocks. Although we had independent parties verify that FAN was capable of trading up to a billion shares per hour, we couldn't gain enough traction to make it commercially viable. So in 1996, we sold FAN to Goldman Sachs and Bernie Madoff. Yes, the same Bernie Madoff who is now serving 140 years for running a Ponzi scheme.

NYSE floor trader blasts high-frequency trading

In our attempts to make FAN viable, we met with firms ranging from Wall Street giants, to then unheard of secretive firms that were virtually out of nowhere trading 10 percent, then 20 percent or more of the NYSE volume. They were the first to discover how much speed was available and how to tweak it so they everything else looked like it was moving in slow motion. They were able to bid faster and sell faster than the market could even see. It was like Superman was moving at light speed jumping in front of you in line as you waited with money in hand to buy concert tickets.

These were the first iteration of HFT shops and they had brilliant programmers and technology that would make the NSA blush. They also kicked off a 20-year technological arms race that forced many, many firms, including my firm (Mercury Trading) out of business. Well, they didn't exactly force us out of business. They'd have gladly picked our pockets in milliseconds for as long as we willingly let them. I should say they made clear that either we spend a million dollars a month on computers, high-speed access and programmers, or we would no longer be in the club.

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Otherwise a stale quote could be hit by the HFT traders hundreds or thousands of times in a single second, wiping out months worth of trading profits in the blink of an eye. We saw the writing on the wall and sold Mercury Trading to one of the larger players, the hedge fund giant Citadel. So that took us from 55 traders on four U.S. exchanges down to three people – me, my brother, Pete, and our accounting and back-office expert, Mary. We then began to develop algorithims to track HFT and other trades in nanosecond timeframes so that we could use the computers to slow down the data and find the big chunky blocks of stock, options or futures that were a tipoff to the next move that stock, option or future was about to take.

So, I know a little bit about good, the bad and the ugly of HFT — and what issues regulators need to address as they seek to provide more effective oversight of these firms.

End special order types. One way HFT traders abused and continue to abuse the system is through the use of special order types. There are hundreds of special order types, such as "hide not slide," which Direct Edge had introduced in 2000. This is where HFT firms use computer commands to tell exchanges how to handle their bids to buy and offers to sell. These may sound innocent, but many of us feel these order types -- and there are literally HUNDREDS of them — give HFTs preferential treatment over the public customers. Any order type that serves to preference HFTs over the public investor should be banned.

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End quote stuffing. Some market participants abuse their access to our capital markets by effectively throwing digital sand in the faces of the millions of investors and traders that do not enjoy the privilege of time and place advantage that HFT firms enjoy. Apparently, it is not enough that HFT firms can react to changes in stock prices in millisecond time frame due to their access via collocation in the data centers of the U.S. stock and futures exchanges. A small number of HFT firms go one step further and "blind" the market by electronically blasting hundreds or thousands of orders into the system and cancelling them in the same millisecond. The obvious goal of this bombardment is to fill the pipe that carries the market data to the poor slobs that do not have collated servers in market data centers, thus slowing transmission of information and creating confusion in the market. That confusion can make other algorithms go into a fail-safe mode, widening out their spreads between bids and offers as well as decreasing the number of shares bid for or offered. The result can become a mini-crash in a given security, or if these attacks are coordinated or the fates intervene, can result in full blown market meltdowns like we saw in the May 2010 flash crash.

End Securities Information Processor (SIP) arbitrage. There are roughly 40 miles between Mahwah, NJ and Carteret, NJ. The NYSE and other exchanges house their data centers in Mahwah and distribute Tape A & Tape B (Securities Information Processor A & B) directly from Mahwah. For some inexplicable reason, the Nasdaq sends its market data to Mahwah from Carteret for dissemination to the public. This allows those collocated HFT firms the opportunity to see the real price at that millisecond for Nasdaq stocks prior to the data being sent to Mahwah for distribution, thus creating a significant arbitrage opportunity for the HFT firms to trade ahead of markets that have already moved.

"Fast Money" trader Jon Najarian is a professional investor, money manager, media analyst and co-founder of optionMONSTER and tradeMONSTER. He worked as a floor trader for 25 years and before that, he was a linebacker for the Chicago Bears. Follow him on Twitter @optionmonster.

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