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To Regulate Rapid Traders, S.E.C. Turns to One of Them

RED BANK, N.J. — As billions of trades course through the stock market each day, investors rely on the government to keep up with Wall Street’s rapid-fire traders.

Flying Colour Ltd. | Photodisc | Getty Images

But in an acknowledgment that the Securities and Exchange Commission has fallen behind the traders it regulates, the agency is turning to one of those high-frequency trading firms for help.

Tradeworx, a 45-person firm based in New Jersey, has dispatched its experts to Washington to tutor regulators on a sophisticated computer program that will give the S.E.C. its first real-time window into the stock market — something firms like Tradeworx have had for years. The S.E.C. program, designed by Tradeworx, is set to go into operation at the end of this year.

The program, called “Midas” by the S.E.C., is part of a broader effort at the agency to monitor the proliferation of new technologies and to crack down on practices that have given sophisticated traders an advantage over ordinary investors. The agency recently hosted public meetings on computerized trading to examine some of the recent failures in the market, like the malfunction at Knight Capital that wreaked havoc on stock prices in August. Last week, the Nasdaqexchange had to cancel errant trades after a technical problem caused shares of Kraft to soar. (Read More: Knight Capital’s Lesson for Individual Investors.)

The S.E.C.’s rudimentary technology has hobbled its ability to untangle these events and police the automated trading firms. With the Tradeworx program, the agency will gain access to every bid to buy stocks and every offer to sell shares on each of the nation’s 13 public exchanges. The system, akin to an X-ray machine for the stock market, could enable regulators to detect whether trading firms are overwhelming the market’s plumbing when they rapidly submit and cancel orders.

“The average person on the street thinks that the S.E.C. has these massive computers that all orders are going through,” said Gregg Berman, the agency official leading the effort. “That has not been the case, but we hope to now have that with this new system.”

Some industry experts have said that the Tradeworx program is the quickest and, at a cost of $2.5 million, the cheapest way for the agency to catch up with the high-speed trading industry, which has gone from being a niche player a decade ago to being responsible for more than half of all trading in American stocks today. But the initiative raises a new set of questions about whether the industry is the best source for unbiased information about the markets.

David Lauer, a former employee of other high-speed trading firms, wrote in recent testimony to a Senate subcommittee that the Tradeworx program was “reminiscent of the fox guarding the hen house.”

“You don’t rely on the subject of your study to build the device you are going to be studying them with,” Mr. Lauer said in an interview after the hearing.

The S.E.C. said it sought out other bids and even considered building its own database, an effort that would have taken several years and cost millions of dollars more than the Tradeworx project. Mr. Berman added that the agency looked to Tradeworx only for data and analytical tools that were the same no matter who provided them.

The chief executive of Tradeworx, Manoj Narang, argued that if he sold bogus data to the government, it would be obvious. More important, he said, the S.E.C. has few alternatives.

“Where else are they going to be able to get these capabilities?” Mr. Narang said. “They are not available from anywhere other than high-speed trading firms. We’re the only ones who possess it.”

Today, the S.E.C. relies on the official trading record, known as the consolidated tape, which includes the price of every trade executed on any of the nation’s stock exchanges. Most sophisticated trading firms bypass the official record by buying data directly from the exchanges. The firms compile a full record milliseconds before the consolidated tape is assembled and obtain a wider range of information, including orders that are submitted but never executed.

Mr. Berman said that data from Tradeworx would be used throughout the S.E.C., from the enforcement division looking to catch wrongdoing to the division of trading and markets that writes rules for Wall Street and keeps daily watch over the markets. The data could allow the S.E.C. to analyze claims that some firms take advantage of their faster data feeds to jump in front of slower traders, and complaints that sophisticated traders can jam the system with so many orders that it slows down trading for others.

Mr. Berman, a former hedge fund co-manager and nuclear physicist, led the agency’s examination of the flash crash of 2010, when stocks plunged nearly 10 percent in half an hour and then mostly recovered. He is now leading the broader effort to bring the S.E.C. into the modern world of trading. As the agency falls farther behind, he is helping to build a new Office of Research and Analytics, which is looking to hire people with experience on Wall Street and in computer programming. The agency is also moving closer to building a so-called consolidation audit trail, which will allow regulators to see the identity of the firm behind every trade.

But any future efforts depend on the S.E.C. having access to the sort of basic data that Tradeworx will provide.

Tradeworx employees have traveled to Washington to train regulators on how to use the program, but they have done most of their work from the company’s brick-walled offices above an Urban Outfitters in the suburban town of Red Bank.

Tradeworx has been a growing player in the high-speed trading industry; Mr. Narang says it now accounts for about 1.5 percent of all daily trading in American stocks. But the company has developed an even more lucrative business selling data and technology to other trading firms. One recent project has involved building towers that can beam trading data to Chicago via microwave, a faster method of transmission than fiber optic cables.

Mr. Narang assembled a five-person team to work full time on the S.E.C. program. It is led by Glenn Nixon, 32, who came to Tradeworx from the Princeton physics program and previously worked on the company’s trading desk.

Tradeworx will give the S.E.C. the same data stream that it sells to its other clients. But the analytical tools it is providing have not been sold before, and are the same ones its trading desk uses to analyze market patterns. The data will be stored in Amazon’scloud network, and Tradeworx will not see how the government is using the system.

The software will give regulators the ability to spot patterns in trading in an individual stock, or to rewind and watch what happened in the trading of all stocks during previous crises, like the Knight Capital incident. Because of the large amounts of data involved, it takes the agency’s current computers weeks to process what the Tradeworx system can do in a day.

Mr. Nixon said he hoped that once the company developed these tools for the S.E.C., his team would market them to other firms. But Mr. Narang said the primary motivation in developing the program was to help regulators respond to critics of high-speed trading.

One of the primary complaints of traditional, slower investors, like mutual funds, is that high-speed trading firms flood the market with orders except in times of crisis, when the orders are most needed. “There are an awful lot of allegations out there that the S.E.C. is not currently in any position to evaluate,” Mr. Narang said. “The S.E.C. ought to be in a position to examine the data and find the truth.”

Even with the new stream of information from Tradeworx, the S.E.C. will still not have the complete picture. It will not, for instance, have information on the trades executed in so-called dark pools, trading venues that do not have to follow the same reporting rules as the public exchanges.

Regulators will also lack information on who is placing the trades, which will come when the consolidated audit trail is completed in a few years. This will be included in the consolidated audit trail that the S.E.C. is developing, but that is not expected to be finished for a few years.

Henry T. C. Hu, a professor of banking and finance law at the University of Texas and a former S.E.C. official, said the agency had been outgunned. He said that while the Tradeworx program was not perfect, the agency needed to do something to catch up.

“You don’t want to let the perfect be the enemy of the good,” Mr. Hu said. “The world is too fast-moving for that.”

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