[Congressional Record (Bound Edition), Volume 156 (2010), Part 2]
[Senate]
[Pages 2261-2264]
[From the U.S. Government Publishing Office, www.gpo.gov]




                         HIGH-FREQUENCY TRADING

  Mr. KAUFMAN. Madam President, I have spoken on the Senate floor many 
times about the importance of transparency in our markets. Without 
transparency, there is little hope for effective regulation. And 
without effective regulation, the very credibility of our markets is 
threatened.
  But I am concerned that recent changes in our markets have outpaced 
regulatory understanding and, accordingly, pose a threat to the 
stability and credibility of our equities markets. Chief among these is 
high-frequency trading.
  Over the past few years, the daily volume of stocks trading in 
microseconds--the hallmark of high-frequency trading--has exploded from 
30 percent to 70 percent of the U.S. market. In the past few years, 
this trading has exploded from 30 percent to 70 percent of the entire 
U.S. trading market.
  Money and talent are surging into a high-frequency trading industry 
that is red hot, expanding daily into other financial markets not just 
in the United States but in global capital markets as well.
  High-frequency trading strategies are pervasive on today's Wall 
Street, which is fixated on short-term trading profits. Thus far, our 
regulators have been unable to shed much light on these opaque and dark 
markets, in part because of their limited understanding of the various 
types of high-frequency

[[Page 2262]]

trading strategies. Needless to say, I am very worried about that.
  Last year, I felt a little lonely raising these concerns. But this 
year, I am starting to have plenty of company.
  On January 13, the Securities and Exchange Commission issued a 74-
page Concept Release to solicit comments on a wide range of market 
structure issues. The document raised a number of important questions 
about the current state of our equities markets, including:

       Does implementation of a specific [high-frequency trading] 
     strategy benefit or harm market structure performance and the 
     interests of long-term investors?

  The SEC also called attention to trading strategies that are 
potentially manipulative, including momentum ignition strategies in 
which ``the proprietary firm may initiate a series of orders and trades 
(along with perhaps spreading false rumors in the marketplace) in an 
attempt to ignite a rapid price move either up or down.''
  The SEC went on to ask:

       Does . . . the speed of trading and ability to generate a 
     large amount of orders across multiple trading centers render 
     this type of a strategy more of a problem today?

  The SEC raised many critical questions in its concept release, and I 
appreciate that the SEC is going to undertake a baseline review.
  As its comment period moves forward, I am pleased to report that 
other regulators and market participants, both at home and abroad, have 
taken notice of the global equity markets' recent changes, including 
the rise in high frequency trading.
  In the United States, the Federal Reserve Bank of Chicago, in the 
March 2010 issue of its Chicago Fed Letter, argued that the rise of 
high-frequency trading constitutes a systemic risk, asserting:

       The high frequency trading environment has the potential to 
     generate errors and losses at a speed and magnitude far 
     greater than that in a floor or screen-based trading 
     environment.

  In other words, high-frequency trading firms are currently locked in 
a technological arms race that may result in some big disasters.
  Citing a number of instances in which trading errors occurred, the 
Chicago Fed stated:

       A major issue for regulators and policymakers is the extent 
     to which high frequency trading, unfiltered sponsor access 
     and co-location amplify risks, including systemic risk, by 
     increasing the speed at which trading errors or fraudulent 
     trades can occur.

  Moreover, the letter cautions about the potential for future high-
frequency trading errors arguing:

       Although algorithmic trading errors have occurred, we 
     likely have not yet seen the full breadth, magnitude, and 
     speed with which they can be generated.

  There is action internationally as well. On February 4, Great 
Britain's Financial Services Secretary, Paul Myners, announced that the 
British regulators were also conducting an ongoing examination of high-
frequency trading practices, stating:

       People are coming to me, both market users and 
     intermediaries, saying that they have concerns about high 
     frequency trading.

  These developments come on the heels of another British effort 
targeting so-called ``spoofing'' or ``layering'' strategies in which 
traders feign interest in buying or selling stock in order to 
manipulate its price. In order to deter such trading practices, the 
Financial Services Authority, FSA, announced that it would fine or 
suspend participants who engage in market manipulation. Noting that 
some market participants may not be sure that spoofing or layering is 
wrong, the FSA spokesman said: ``This is to clarify that it is.''
  In Australia, market participants are also requesting clearer 
definitions of market manipulation, particularly with regard to 
momentum strategies such as spoofing. In a review of algorithmic 
trading published on February 8, the Australian Securities Exchange 
called on its regulators to ``ensure that . . . market manipulation 
provisions . . . are adequately drafted to capture contemporary forms 
of trading and provide a more granular definition of market 
manipulation.''
  It is critical our regulators understand the risks posed by high-
frequency trading both in terms of manipulation and at a systemic 
level. As the Chicago Fed stated, the threat of an algorithmic trading 
error wreaking havoc on our equities markets is only magnified by so-
called ``naked'' or unfiltered sponsored access arrangements, which 
allow traders to interact on markets directly--without being subject to 
standard pretrade filters or risk controls.
  Robert Colby, the former Deputy Director of the FEC's Division of 
Trading and Markets, warned last September that naked access leaves the 
marketplace vulnerable to faulty algorithms. In a speech given at a 
forum on the future of high-frequency trading, which was cited by the 
Chicago Federal Reserve's recent letter, Mr. Colby stated that hundreds 
of thousands of trades representing billions of dollars could occur in 
the 2 minutes it could take for a broker-dealer to cancel an erroneous 
order executed through naked access.
  According to a report released December 14 by the research firm Aite 
Group, naked access now accounts for a staggering 38 percent of the 
market's average daily volume compared to only 9 percent--compared to 9 
percent--only 4 years ago. That means in just 4 years, what has been 
determined to be a risky enterprise has increased from 9 percent of the 
market's average daily volume to 38 percent. That is almost 40 percent 
of the market's volume being executed by high-frequency traders 
interacting directly on exchanges without being subject to any pretrade 
risk monitoring.
  In January, the SEC acted to address this ominous trend by proposing 
mandatory pretrade risk checks for those participating in sponsored 
access arrangements. This move would essentially eliminate naked 
access, and I applaud the SEC for its proposal.
  While I am pleased that the SEC has taken on naked access and has 
issued a concept release on market structure issues, there is much more 
work that still needs to be done in order to gain a better 
understanding of high-frequency trading strategies and the risks of 
front running and manipulation they may create. In the last few months, 
several industry studies aimed at defining the benefits and drawbacks 
of high-frequency trading have emerged. While these studies may not be 
the equivalent of a peer-reviewed academic study, they do have the 
credibility of real-world market experts, and they begin to shed light 
on the opaque and largely unregulated, high-frequency trading 
strategies that dominate today's market.
  In addition to the Aite Group study, reports by the research group, 
Quantitative Services Group, QSG; the investment banking firm, 
Jefferies Company; the dark pool operator, Investment Technology Group, 
ITG; and the institutional brokerage firm, Themis Trading, all raise 
troubling concerns about the costs of high-frequency trading to 
investors and reinforce the need for enhanced regulatory oversight of 
these trading practices.
  Last November, QSG analyzed the degree to which orders placed by 
institutional investors are vulnerable to high-frequency predatory 
traders who sniff out large orders and trade ahead of them. 
Specifically, the study concluded that splitting large orders into 
several smaller ones not only enhances the risk of unfavorable changes 
in price but also increases ``the chances of leaving a statistical 
footprint that can be exploited by the `tape reading' HFT algorithms.''
  While traders have long tried to trade ahead of large institutional 
orders, they now have the technology and models to make an exact 
science out of it.
  In a study put forth on November 3, the Jefferies Company examined 
the advantages high-frequency traders gain by colocating their computer 
servers next to exchanges and subscribing directly to market data 
feeds.
  Jefferies estimates that these advantages afford high-frequency 
traders a 100- to 200-millisecond advantage over those relying on 
standard data providers. As a result, Jefferies concludes, high-
frequency traders enjoy ``almost risk-free arbitrage opportunities.''
  A Themis Trading white paper released in December elaborated on

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Jefferies' conclusion, noting that the combination of speed and 
informational advantages allow high-frequency traders to ``know with 
near certainty what the market will be milliseconds ahead of everybody 
else.''
  The studies and papers I have mentioned underscore the need for the 
Securities and Exchange Commission to implement stricter recording and 
disclosure requirements for high-frequency traders under a large trader 
authority, as Chairman Mary Schapiro promised in a letter to me on 
December 3. We need--and we need now--tagging of high-frequency trading 
orders and next-day disclosure to the regulators, and we need them now.
  For investors to have confidence in the credibility of our markets--
and that is absolutely key. America is great because of the credibility 
of our markets. If we don't have credible markets, we are in deep 
trouble. It is one of the things that makes America great and unique. 
For investors to have confidence in the credibility of our markets, 
regulators must vigorously pursue a robust framework that maintains 
strong, fair, and transparent markets.
  I would make five points along these lines.
  First, the regulators must get back in the business of providing 
guidance to market participants on acceptable trading practices and 
strategies. While the formal rulemaking process is a critical component 
of any robust regulatory framework, so, too, are timely guidelines that 
bring clarity and stability to the marketplace.
  Colocation, flash orders, and naked access are just a few practices 
that seem to have entered the market and have become fairly widespread 
before being subject to regulatory scrutiny. For our markets to be 
credible--and it is essential that they remain credible--it is vital 
that regulators be proactive--rather be reactive, when future 
developments arise.
  Second, the SEC must gain a better understanding of current trading 
strategies by using its ``large trader'' authority to gather data on 
high-frequency trading activity. Just as importantly, this data, once 
masked, should be made available to the public for others to analyze.
  I am concerned that academics and other independent market analysts 
do not have access to the data they need to conduct empirical studies 
on the questions raised by the SEC in its concept release. Absent such 
data, the ongoing market structure review predictably will receive 
mainly self-serving comments from high-frequency traders themselves and 
from other market participants who compete for high-frequency volume 
and market share.
  Evidence-based rulemaking should not be a one-way ratchet because all 
the ``evidence'' is provided by those whom the SEC is charged with 
regulating. We need the SEC to require tagging and disclosure of high-
frequency trades so that objective and independent analysts--at FINRA, 
in academia, or elsewhere--are given the opportunity to study and 
discern what effects high-frequency trading strategies have on long-
term investors. They can also help determine which strategies should be 
considered manipulative.
  Third, regulators must better define manipulative activity and 
provide clear guidance for traders to follow just as Britain's 
regulators have done in the area of scrutiny. By providing rules of the 
road, regulators can create a system better able to prevent and 
prosecute manipulative activity.
  Fourth, the SEC must continue to make reducing systemic and 
operational risk a top regulatory priority. The SEC's proposal on naked 
access is a good first step, but exchanges must also be directed to 
impose universal pretrade risk tests. If that is solely in the hands of 
individual broker-dealers, a race to the bottom might ensue. We simply 
must have a level playing field when it comes to risk management that 
protects our equities markets from fat fingers or faulty algorithms. 
Regulators must therefore ensure that firms have proprietary 
operational risk controls to minimize the incidence and magnitude of 
any such errors while also preventing a tidal wave of copycat 
strategies from potentially wreaking havoc on our equity markets.
  Fifth, the SEC should act to address the burgeoning number of order 
cancellations on the equities markets. While cancellations are not 
inherently bad--they can in fact enhance liquidity by affording 
automated traders greater flexibility when posting quotes--their use in 
today's marketplace, however, is clearly accessible and virtually a 
prima facie case that battles between competing algorithms, which use 
cancelled orders as feints and indications of misdirection, and have 
become all too commonplace, overloading the system and regulators 
alike.
  According to the high-frequency trading firm T3Live, on a recent 
trading day only a little more than 1 billion of the over 89 billion 
orders on NASDAQ's book were ever executed, meaning a whopping 99 
percent of total bids and offers were not filled. Cancellations by 
high-frequency traders, according to T3Live, are responsible for the 
bulk of these unfilled orders.
  The high-frequency traders that create such massive cancellation 
rates might cause market data costs for investments to rise, make the 
price discovery process less efficient, and complicate the regulator's 
understanding of continuously evolving trading strategies. What is 
more, some manipulative strategies, including layering, rely on the 
ability to rapidly cancel orders in order to profit from changes in 
price.
  Perhaps excessive cancellation rates should carry a charge. If 
traders exceed a specified ratio of cancellations to orders, it is only 
fair that they pay a fee. The ratio could be set high enough so that it 
would not affect long-term investors or even day traders and should 
apply to all trading platforms, including dark pools and ATSs, as well 
as exchanges.
  The high-frequency traders who rely on massive cancellations are 
using up more bandwidth and putting more stress on the data centers. 
Attempts to reign in cancellations or impose charges are not without 
precedent. In fact they have already been implemented in derivatives 
markets where overall volume is a small fraction of the volume in cash 
market for stocks. The Chicago Mercantile Exchange's volume ratio test 
and the London International Financial Futures and Options Exchange's 
bandwidth usage policy both represent attempts to reign in excessive 
cancellations and might provide a helpful model for regulators wishing 
to do the same.
  Finally, the high frequency trading industry must come to the table 
and play a constructive role in resolving current issues in the 
marketplace, including preventing manipulation and managing risk. In 
order to maintain fair and transparent markets and avoid unintended 
consequences, market participants from across the industry must 
contribute to the regulatory process. I am pleased that a number of 
responsible firms are stepping forward in a constructive way, both in 
educating the SEC and me and my staff. I look forward to continue to 
working with these industry players.
  We all must work together, in the interests of liquidity, efficiency, 
transparency and fairness to ensure our markets are the strongest and 
best-regulated in the world. But we cannot have one with the other--for 
markets to be strong, they must be well-regulated. So with this reality 
in mind, I look forward to working with my colleagues, regulatory 
agencies, and people from across the financial industry to ensure our 
markets are free, credible and the envy of the world.
  Madam President, I ask unanimous consent that links to some of the 
studies I have mentioned be printed in the Record.
  There being no objection, the following material was ordered to be 
printed in the Record, as follows:

       www.qsg.com
       ``Liquidity Charge' & Price Reversals: Is High 
     Frequency Trading Adding Insult to Injury?'' February 11, 
     2010
       ``Beware of the VWAP Trap,'' November 11, 2009
     http://www.themistrading.com/article_files/
0000/0519/THEMIS_TRADING_White_Paper_
     Latency_ Arbitrage_December_4_2009.pdf
       http://www.itg.com/news_events/papers/
AdverseSelectionDarkPools_113009F.pdf

  I yield the floor and suggest the absence of a quorum.

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  The PRESIDING OFFICER. The clerk will call the roll.
  The legislative clerk proceeded to call the roll.
  Ms. MIKULSKI. Madam President, I ask unanimous consent that the order 
for the quorum call be rescinded.
  The PRESIDING OFFICER. Without objection, it is so ordered.

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