(High frequency or flash trading refers to the growing practice of investment houses like Goldman Sachs to locate and program servers next to exchanges, giving them split second advance access to market information which allows them to engage in automated front-running, executing orders on their own account ahead of their customers and other traders.)
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Due to rapid technological advances in computerized trading, the stock markets have changed dramatically in recent years. They have become so highly fragmented that they are opaque - beyond the scope of effective surveillance. And our regulators have failed to keep pace.
The facts speak for themselves. We've gone from an era dominated by a duopoly of the New York Stock Exchange and Nasdaq to a highly fragmented market of more than 60 trading centers. Dark pools, which allow confidential trading away from the public eye, have flourished, growing from 1.5 percent to 12 percent of market trades in under five years.
Competition for orders is intense and increasingly problematic. Flash orders, liquidity rebates, direct access granted to hedge funds by the exchanges, dark pools, indications of interest, and payment for order flow are each a consequence of these 60 centers all competing for market share.
Moreover, in just a few short years, high frequency trading - which feeds everywhere on small price differences in the many fragmented trading venues - has skyrocketed from 30 to 70 percent of the daily volume.
Indeed, the chief executive of one of the country's biggest block trading dark pools was quoted two weeks ago as saying that the amount of money devoted to high-frequency trading could "quintuple between this year and next."
Mr. President, we have no effective regulation in these markets.
Last week, Rick Ketchum, the Chairman & CEO of the Financial Industry Regulatory Authority - the self-regulatory body governing broker-dealers - gave a very thoughtful and candid speech, which I applaud. In it, Mr. Ketchum admitted that we have inadequate regulatory market surveillance.
His candor was refreshing but also ominous: "There is much more to be done in the areas of front-running, manipulation, abusive short selling, and just having a better understanding of who is moving the markets and why."
Mr. Ketchum went on to say:
There are impediments to regulatory effectiveness that are not terribly well understood and potentially damaging to the integrity of the markets...The decline of the primary market concept, where there was a single price discovery market whose on-site regulator saw 90-plus percent of the trading activity, has obviously become a reality. In its place are now two or three or maybe four regulators all looking at an incomplete picture of the market and knowing full well that this fractured approach does not work.
Mr. President, at the same time that we have no effective regulatory surveillance, we have also learned about potential manipulation by high frequency traders.
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...One industry expert has warned about high-frequency malfunctions:
The next Long Term Capital meltdown would happen in a five-minute time period. ... At 1,000 shares per order and an average price of $20 per share, $2.4 billion of improper trades could be executed in [a] short time frame.
This is a real problem, Mr. President. We have unregulated entities - hedge funds - using high frequency trading programs interacting directly with the exchanges.
As Chairman Reed said at last week's hearing, nothing requires that these people even be located within the United States. Known as "sponsored access," hedge funds use the name of a broker-dealer to gain direct trading access to the exchange - but do not have to comply with any of the broker-dealer rules or risk checks.
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Even those on Wall Street responsible for overseeing their firms' high frequency programs are not up to speed on the risks involved, according to a recent study conducted by 7city Learning. In a survey of quantitative analysts, who design and implement high frequency trading algorithms, two-thirds asserted their supervisors "do not understand the work they do."
And though quants and risk managers played a central role exacerbating last year's financial crisis, 86% of those surveyed indicated their supervisors' "level of understanding of the job of a quant is the same or worse than it was a year ago," and 70% said the same about their institutions as a whole.
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Full: http://www.huffingtonpost.com/sen-ted-kaufman/breaking-wall-streets-boo_b_348494.html