New York Attorney General Eric Schneiderman announced Tuesday a broad investigation into whether US exchanges and alternative venues such as dark pools provided high frequency trading firms unfair advantages.  Not coincidentally the move comes nearly one week after the Commodity Futures Trading Commission launched an investigation into Virtu, the high frequency trading (HFT) firm that publically boasts a nearly 99.9999% win percentage on its trades and is planning an initial public offering.

Eric Schneiderman Virtu HFT

The two moves against the practice of HFT carry important similarities and seem to strike at the core of the practice that some are now calling to be outlawed.  For his part, Eric Schneiderman indicated certain aspects of HFT, as it is currently constituted, may be illegal, which led to Bloomberg’s Jonathan Weil asking that Schneiderman spell out exactly what is illegal.

The potential illegality can be ascertained from both Schneiderman’s somewhat cryptic statements but more specifically from the CFTC investigation of Virtu – which share key elements that are concerning market watchers.

Potential illegality focuses on special advantages exchanges provide HFT firms

The focus of both the CFTC regulatory probe and the New York Attorney General’s ire is an exchange providing trading benefits to certain HFT players that, if it occurred on the trading floor, could be considered either illegal or a violation of the rules.  Certain exchanges provide benefits to HFT firms (including market makers) to enter their markets.

Such benefits include placing HFT orders ahead of orders that have been sent to the exchange first or more subtly providing access to exchange servers at tremendous expense (and profit to the exchange) which effectively allows HFT firms to enter the markets in front of other orders. Other issues focus on exchanges providing trading rebates to select HFT firms.

Exchange allowing HFT orders to cut ahead in line of “average” orders

A key component of fair and open markets is that an exchange provides equal and unbiased treatment to all orders.  Exchange and regulatory rules had traditionally kept a close eye on trading floor activity to ensure that a broker does not “front run” orders that come into the pit.  But with the advent of HFT, some exchanges enable such behavior.

Such benefits include placing the HFT firm’s order ahead of other traders / investors even though the HFT order entered the market after other firms.  On the exchange floor, if a floor broker were to give preferential treatment to orders from a related financial beneficiary over other orders who had been waiting in the market longer, the trader could face exchange fines and, depending on the circumstance, criminal charges.

“If preferential order treatment isn’t illegal,” one regulatory source said, “it should be.”

While exchanges can explicitly allow an HFT trade order to cut ahead of the line in front of other orders, there are more subtle methods

Where is the most expensive real estate in town?  Next to the exchange server.

Another method to provide HFT firms concrete trading advantage, enabling their orders to hit the exchange book ahead of major institutional investors and mom and pop traders alike, is to “rent” the preferential treatment.

Exchanges are known to rent space in their secure internet server facility at astronomical prices.  Such proximity to the trading server provides the HFT firms access to the server ahead of other traders.

For instance the CME Group Inc (NASDAQ:CME)’s trade server, located in the western suburbs of Chicago, rents out a 2’ X 3’ server space for as much as $40,000 per month, according to multiple sources, making it by far the most expensive real estate in this or any city.  CMEGroup did not respond to requests to comment.

Exchanges tend not to publicly list the availability of such preferential server access to the public, and some are said to only offer access to select firms. In a related note, Schneiderman had worked with Business Wire to “encourage” the firm to discontinue offering HFT firms preferential access to stock earnings information due to their server set up.  Using this server configuration, HFT firms were able to pay Business Wire significant amounts of cash to receive and trade on earnings news ahead of the general public, generating millions in profits. Business Wire was said not to advertise the service to the general public and did not disclose its pricing or existence.  Former SEC Chairman Arthur Levitt called this a likely violation of the SEC’s Reg Fair Disclosure, as exclusively reported in ValueWalk.

Paying for order flow

Another issue with HFT is the payments that large traders receive from exchanges, the subject of a recent CFTC investigation.

According to a report in today’s Wall Street Journal, the CFTC investigation is focused on “often opaque incentive programs that give high-volume trading firms financial benefits such as discounts on fees the exchanges charge to execute trades.”  The report noted the SEC is similarly engaged in review of advantages stock exchanges provide to HFT firms that provide preferential treatment to their orders.

“There shouldn’t be secret deals,” Mark Gorton, chief executive of Tower Research Capital, a U.S. high-frequency trading firm, was quoted as saying. “The big players shouldn’t have better rates than the little players.”

Former CMEGroup board director Jeffery Carter notes that the practice is troubling all the way around. “Not only do rebates unbalance the playing field and make it less competitive, but rebates hurt the total top line revenue of an exchange…”

The incentives and high costs of HFT have actually forced smaller HFT firms out of the business.  “HFT has dramatically changed,” said the president of one former Chicago-based HFT firm.  “It used to be based on market-based momentum trading strategy that was similar to floor strategy. Now it’s about a costly high speed arms race and connections to get exchange benefits,” the former floor trader said, noting why he left the industry. “If on the floor I used HFT methods to front run orders and pay for preferential treatment, I would be in jail.”

Providing preferential treatment in the spotlight

Providing HFT traders preferential treatment is the subject of the CFTC probe into Virtu.  As previously discussed in a ValueWalk article, the HFT firm boasts revenues of over $1 million per day and a 99.9999% win percentage on its trade, but the question is will the benefits it receives from the exchanges last?

“Exchanges should be neutral,” wrote Carter, author of the Points and Figures blog. “Today, exchanges are definitely not neutral…”

While exchanges stand to lose significant revenue from the HFT firms if changes are made, Carter, like other market observers, believes leveling of the playing field would not necessarily reduce overall volume but enable a broader group to participate.  “Most of the guys that I know running HFT firms are highly competitive and play it straight,” he wrote. “If you took away the rebates, and the co-location advantage they have, they would survive.  They are smart traders and know markets-and are willing to assume risk.”