SEC Expands Probe Into Whether Exchanges Favor HFT

As the spotlight continues to shine on the controversial practice of high frequency trading, regulators are now ramping up their probe of exchanges in an effort to pinpoint whether they are giving unfair trading advantages to sophisticated investors.

The heightened regulatory scrutiny comes on the heels of a series of major technical glitches that have damaged investor confidence in today’s increasingly fast, electronic markets.

High-profile technology snafus have recently hit Nasdaq, which seriously stumbled over Facebook’s IPO, BATS, which botched its own IPO and Knight Capital which suffered an embarrassing $440 million software malfunction that almost put the trading powerhouse out of business.

With high-frequency trading now making up more than 50% of all trading volume, regulators are intent on investigating whether high speed traders are exploiting complex computer systems at exchanges in ways that can hurt regular investors, as well as whether exchanges have sometimes helped them to do this.

As such, the SEC is now looking at how exchanges develop new products, communicate with investors and provide incentives to trade as part of its investigation into trading order types, which allow traders to control how their buy and sell orders are treated, according to the Wall Street Journal.

The watchdog is looking at how order types are developed, vetted, approved and tested, and how they interact with other investor orders, the Journal notes. Regulators are concerned that exchanges may have given some firms more information about how their trading systems operate than they gave others.

From the WSJ:

Order types can control how much an investor will pay for a stock, whether the order can be routed to another exchange and whether the order will move up or down in price, among other things.

A number of order types benefit high-speed traders, whose activity comprises more than half of all stock-trading volume.

The order-type investigation caused SEC officials to conclude that continuing regulation of exchanges needs to be toughened, regulatory officials say. The SEC has expanded its scrutiny of order types from its enforcement division to its Office of Compliance Inspections and Examinations, or OCIE, which oversees how exchanges, brokers and other securities firms comply with regulations.

OCIE's involvement indicates that regulators are looking beyond specific order-type concerns into long-standing procedures at exchanges involving how they craft order types, who they give information about order types to, and whether their public disclosures adequately explain how order types work.

Ultimately, the SEC could require exchanges to disclose more details about how their order types work and how they interact with other trading orders. Regulators could also take a tougher stance in approving new order types, according to the WSJ.

In the meantime, the SEC reportedly has already asked exchanges for emails and other records of communications with trading clients regarding how order types work. Beyond order types, examiners are also looking at whether high-speed data feeds are being used unfairly by some sophisticated firms to detect big orders placed by institutional investors.

SEC Chairman Mary Schapiro has said the regulator is considering taking action that could curb orders high-frequency firms deploy, including imposing a small fee on buy and sell orders.

Melanie Rodier has worked as a print and broadcast journalist for over 10 years, covering business and finance, general news, and film trade news. Prior to joining Wall Street & Technology in April 2007, Melanie lived in Paris, where she worked for the International Herald ... View Full Bio