HFT Firms Brace for a New, Bolder SEC

Given the twists and turns of 2011, predicting what 2012 holds in store for Wall Street is anyone's gamble. After all, who could have predicted that MF Global would lose $1.2 billion of customer money held in segregated accounts? Or that Pipeline Trading Systems would deceive its clients by matching their order flow against a proprietary trading affiliate's order flow, while marketing this as natural liquidity? And who could have foreseen the conviction of Galleon Group's Raj Rajaratnam or the implosion of expert research networks such as Primary Global that were exposed for giving insider-trading tips to hedge fund executives?

Fortunately, we have the past to guide us. If 2011 is any indication of 2012's agenda of leftover problems, in the year ahead regulators will keep a keen eye on high-frequency trading, dark pools and rogue algorithms, areas that have been characterized by inertia for the past two years. And let's not forget Dodd-Frank, which still requires many rules -- including the definitions of a swaps dealer and the proprietary trading activity that will be banned under the Volcker Rule -- to be finalized.

Making headway on any of these issues is a tall order for the regulatory bodies, which have been stymied by Wall Street lobbyists and tight budgets courtesy of the Republicans in Congress who blame President Obama's financial overhaul for prolonging the U.S. economy's slow growth. But with $1 billion in its budget and more teeth behind the SEC enforcement division's bite, 2012 could be the year in which the Securities and Exchange Commission regains some respect. For starters, the regulator is expected to resume its focus on equity market structure and weigh in on the role of high-frequency traders, which David Dreman, a respected contrarian investor, compared in a recent Forbes blog post to vultures swooping in on instability and wreaking havoc with institutional portfolios.

Complaints about HFT firms profiting from or accentuating volatility are not new. But high-frequency traders have become the primary liquidity providers in U.S. equities, and nothing is going to change that any time soon. It's unlikely that regulators will do much in 2012 for fear of dampening the hyperactive liquidity they provide.

While various remedies have been proposed for reining in HFT firms -- including mandating market-making obligations, requiring them to hold their bids and offers a few millionths of a second longer, or taxing them for excessive message rates pumped through the exchanges' pipes -- so far nothing has been implemented. What could change is the SEC's ability to track HFT with the implementation of the large-trader reporting rule. This year, the SEC is expected to adopt a consolidated audit trail and collect the data necessary to monitor activity across securities and security-based swap markets, including high-frequency trading. With Wall Street downsizing as many as 200,000 jobs to cut expenses and deal with falling trading revenues, perhaps some of the math whizzes and IT experts will land jobs with the SEC and CFTC, where they can apply their analytical skills to handle complex data sets.

Providing more transparency into dark pools is another issue that has been dead at the altar for several years. One of the biggest stories of 2011 was the Pipeline Trading scandal, in which the operator of a leading dark pool paid a $1 million fine to the SEC for failing to disclose that buy-side customer orders were matched against proprietary flow while claiming that the crossing network matched customer order flow against natural liquidity from other customers. But while the scandal has damaged trust in dark pools, buy-side institutions are not screaming for the SEC to intervene by monitoring dark pool routing practices. Rather, we could see the emergence of a new business: analyzing the activity in dark pools to find out if gaming is occurring or if outbound IOIs are causing leakage. Dark pool aggregators filling the role of neutral intermediaries could be in a position to offer such a service.

2012 also may be the year in which customers of bankrupt MF Global find out where their missing money went and who authorized the transfers of funds out of their segregated accounts. Will this be the year in which criminal charges are filed against former CEO and New Jersey Senator Jon Corzine (or his lieutenants), even though he denied authorizing the transfers or knowing anything about them?

Meanwhile, 2012 also is an election year, and the role of government oversight of business could be a hot-button issue. One thing is certain: 2012 won't be boring.