How the SEC Profits from High-Frequency Trading

"The markets are not rigged."

That's what U.S. Securities and Exchange Commission Chairwoman Mary Jo White told a House of Representatives panel on Tuesday.

She went on to say, "The U.S. markets are the strongest and most reliable in the world."

Of course she's right. The U.S. markets are the strongest and most reliable in the world.

But she's either blind or deluded if she doesn't know they are also rigged...

The SEC's Case of Cultivated "Confusion"

What prompted Chair White's defense of the markets she and the SEC are charged with regulating to ensure they are fair and transparent was a point-blank question posed by Congressman Scott Garrett, a New Jersey Republican.

Mr. Garrett, who sits on the House Financial Services Committee, was referring to Michael Lewis' explosive book, Flash Boys, and Lewis' claim that high-frequency traders have rigged the markets.

Mary Jo White is not only not deluded, but she is extremely bright.

She has a B.A. from the College of William & Mary, an M.A. in psychology, and a law degree from Columbia Law School, where she was the Writing and Research Editor of the Columbia Law Review. In March of 1993 Ms. White was appointed by President Bill Clinton as U.S. Attorney for the Southern District, which reigns over Wall Street.

In other words, she's no stranger to what insider trading really is.

She claimed that using high-speed access to exchange servers to determine market bids and offers before they are disseminated to the public, which is what high-frequency traders do to jump ahead of unsuspecting investors, doesn't actually meet the legal definition of "unlawful insider trading."

"There's some confusion about that," she said. It must have been Ms. White's law background and her tenure as a U.S. Attorney that so carefully measured her response.

What there isn't any confusion about is that the SEC has opened up an investigation into high-frequency trading. So have the FBI, the Justice Department, and the New York State's Attorney General.

The only confusion here is on the part of Ms. White. It boggles the mind to listen to the top regulator on Wall Street, of equity trading and all the stock exchanges, to say front-running public orders isn't at least some form of "insider trading."

Of course it is. The truth is the American public can't handle the truth.

The truth is that the Securities and Exchange Commission knows exactly how high-frequency traders operate, that they have unfair access to market data ahead of the public, and that they make billions of dollars a year plying their middleman, toll-taking techniques.

Mary Jo White, like her predecessors, has simply turned a blind eye to what's become of the markets. And the reason the regulators have turned a blind eye is that they have been paid to do so.

The SEC Won't Turn Off Their Money-Making Spigot

High-frequency traders pay exchanges for their order flow. That means even a start-up exchange with no business to speak of has a chance to grow into a bona-fide exchange that pays all kinds of registration and other fees to the SEC.

Exchanges want orders from brokers; their job is to match them and execute trades.

For exchanges to get orders sent to them, they pay brokerages for their order flow. "Order flow" refers to the orders that customers send to the likes of E-Trade, to Fidelity, to Charles Schwab, and to all the discount brokerage houses and every other brokerage house that isn't a big broker-dealer like Merrill Lynch. Merrill Lynch and the big broker-dealers trade off their own order flow, at the expense of its customers.

Where do the exchanges get the money to pay brokerages for their order flow? They are paid by HFT operators to look inside their servers that gather bids and offers on all the stocks they trade on their exchange. That's how the HFT lads get a sneak peak; they pay for it. It's how the game is run.

Mary Jo White has to pretend she's blind. The SEC has aided and abetted the growth of HFT.

The New York Stock Exchange had to come to them to ask if they could build a 400,000 square foot server farm in New Jersey. It wasn't for the NYSE to house their few servers, but to house the servers of HFT shops who are being charged top dollar to place their computers next to the Exchange's computers so their access time to them can only be counted in millionths of a second.

HFT operators then used their huge cash hoards and started buying up properties near the NYSE's new mega-warehouse, so they could be close but not have to pay exorbitant rental charges at the warehouse.

How could the SEC have allowed the NYSE to make a rule that forbids HFT shops from locating outside the warehouse, without knowing what was going on?

And then there are all the new order-types that exchanges get from HFT shops. Trust me, you've never heard of any of these order types, because they make no sense to an investor or trader who ever placed an order with an exchange to execute a trade for them.

What's the purpose of putting down an order to buy 50,000 shares at the limit price you specify and then wanting to cancel the order after you've bought only 100 shares? That's not a market order, or a limit order, or an order that any of us are familiar with. And I'm familiar with them all. That's a special order type that HFT shops had to ask exchanges to let them submit. And the SEC has to approve what the exchanges do.

The Questions That No One Will Ask

What's the purpose of an order like that? It's to "ping" the market, to see if there are a lot of shares to sell at the price probed. The HFT buyer didn't want to buy 50,000 shares, they just wanted to see how many shares are for sale. Why? So they can short the stock ahead of the sellers. There are all kinds of "new" orders like that one.

Someone needs to ask Mary Jo White, and I'd like to be the one, how did these new order types come about? Who uses them? Why and for what? And, who approved them?

I'd like to ask the SEC Chairwoman how much the exchanges they regulate make off HFT shops? How much does the SEC collect in fees from the exchanges and from HFT shops, and how much does all this new "business" add to their fee collection plate?

It's not that the SEC is living off these fees; it's that the money is being made somewhere, and if they don't know where it's being made under their watch, then they're either blind or in bed with everyone in the game.

And the truth is they are. That's why the markets are rigged. They're not rigged under the "legal definition" of rigged, as in a crooked rigging. They're rigged the way sails on a sailing ship are rigged. They are part of how the vessel gets from point A to point B.

It's just the way it is. Thanks to the SEC.

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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