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Originally published February 22, 2012 at 10:06 PM | Page modified February 23, 2012 at 10:38 AM

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SEC seems stymied by complexity of high-frequency trading

Trying to get a handle on the impact of high-frequency trading, which is practiced by technologically turbocharged investors, illustrates how regulators are often hard-pressed to keep up with the financial industry, especially where technology is involved.

The Washington Post

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WASHINGTON — Chairman Mary Schapiro of the Securities and Exchange Commission (SEC) is worried about the rise of high-frequency trading, but two years after the agency flagged the phenomenon as a potential problem, she says regulators still don't know enough to do much more about it.

High-frequency trading, which is practiced by hedge funds and other technologically turbocharged investors, involves the purchase and sale of large volumes of shares in tiny fractions of a second, often to exploit fleeting inconsistencies in the markets.

At a wide-ranging question-and-answer session with reporters Wednesday, Schapiro said that major regulators from various countries gathered in the fall to confidentially compare notes about high-frequency trading.

"And we all concluded that we have concerns but we don't have enough data yet to really be able to justify significant additional steps at this point," Schapiro said. "We need to have a much deeper understanding of the impact of high-frequency trading on our markets."

The issue illustrates how regulators are often hard-pressed to keep up with the financial industry, especially where technology is involved.

In January 2010, the SEC published a long list of questions about high-frequency trading and asked the public for help answering them. The agency asked whether conventional, long-term investors are left at a disadvantage and whether "harmful" trading strategies were so widespread that the SEC should write new rules.

One concern: that high-frequency traders might be triggering rapid price movements that they could then exploit.

Many exchanges sell a service called "co-location" — which allows traders to place their computer servers closer to the heart of the exchange and thereby reduce the transmission time for market data and order messages, the SEC noted. When trading advantages are measured in mere thousands or millionths of a second, co-location could be the difference between success and failure.

Last year, a congressionally mandated consultant's report on the SEC said high-frequency trading accounted for about 56 percent of the stock trading volume in the United States, up from 35 percent in 2005. The behavior of high-frequency traders is believed to have contributed to the "flash crash" of May 6, 2010, when markets swung wildly, the report said. Such trading "creates new potential for market manipulation" and can create "an uneven playing field," the report by Boston Consulting Group said.

Schapiro expressed concerns of her own Wednesday, lamenting the current volume of trading that is "unrelated to the fundamentals of the company that's being traded."

"It's got very little to do with whether you think IBM's got a great business plan and solid earnings growth in its future ... and a lot more to do with what's the minuscule aberrational price move that you can take advantage of because you've co-located your computer with the exchange and can jump on that in microseconds," she said.

"And that worries me in some ways."

The SEC has taken some steps to address the issue, such as mandating a new reporting system that will require brokerage firms to track transactions by their large traders.

"That data is going to be critical to our ability to justify further changes in the equity market structure," Schapiro said.

The agency only has so much bandwidth to tackle the subject, and the same SEC staff members who specialize in that area are busy working on rules to implement the Dodd-Frank Act that Congress drafted in response to the financial crisis.

"We simply can't do it all at once," Schapiro said.

Asked what keeps her up at night, Schapiro said she feels "a sense of urgency" about money market funds, which are susceptible to the equivalent of a run on the bank.

The agency has been working on proposals to make the funds more resilient, but previews of the agency's plans have met strong resistance from the fund industry.

"There is a structural weakness that makes them prone to runs, and I feel like we need further debate and discussion around some concrete ideas there," she said.

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