The debate over high-speed trading (high-frequency trading news) and its effect on the overall market will not be resolved anytime soon. Regulators are certainly taking an interest. But while it would be wrong to demonize high-frequency trading--which adds massive amounts of liquidity to the system--it would be equally wrong to overlook some of the problems. 

Not too long ago, we noted a study by Quantitative Services Group that found high-frequency traders used "pattern-recognition software to see footprints that block orders leave from algorithmic trades. High-frequency traders then buy alongside institutions, pushing up the price they pay." They sell the stock to the institutions for a profit. About 20 percent of the orders in the study had "significantly" higher-than-average costs that were then usually followed by big price declines, suggesting that someone is sniffing out institutional orders and trading on the information. 

Some related issues have more recently been flagged by Themis Trading, an agency broker that has emerged as an influential critic of the high-frequency trading world. It released a report last month entitled "Latency Arbitrage: The Real Power Behind Predatory High Frequency Trading," that contends that some high-frequency and algorithmic traders are gaming the system by trading on market data before it gets to other investors--a practice that has been dubbed latency arbitrage. 

How is this possible? Some trading firms pay tens of thousands of dollars in subscription fees to individual exchanges in return for access to their direct price feeds. These feeds get to them before the consolidated data feeds are distributed broadly. Obviously, this is valuable information that firms could easily use in an era of split second trading. Effectively, this is foreknowledge of where stock prices are heading. This advance knowledge of coming changes in the national best bid and offer price can provide an advantage of about 100 to 200 milliseconds over investors who lack the direct feeds, according to one estimate. 

Themis trading soon issued a follow-up paper, "Exchanges and Data Feeds: Data Theft on Wall Street," that went even further: "Now, we have discovered that at least two of the exchanges, in addition to providing that information, also provide data that enable HFTs to track specific trade orders, putting institutional trading strategies at further risk. Put simply, every day, certain market centers are marketing and providing data feeds where they are revealing more information than just the original order, depth of book and trade executions." It identified two specific occurrences: the BATS Exchange direct feed known as BATS PITCH and the NASDAQ direct feed known as TotalView-ITCH. 

The response was interesting. In Europe, volume on the LSE's Turquoise spiked initially, as customers grew restive about Chi-X and BATS Europe. Both firms ended up making  some fast corrective changes. Chi-X Europe no longer discloses customer identification or order numbers in Chi-Delta, its dark pool. Bats Europe also stopped such disclosure. Both firms were responding to comment from the customers, who were afraid, fairly or not, that their trading strategies could be comprised. 

We could see similar activity in the U.S. ahead of any major regulatory moves. In general, the dark pool and exchange community is quite aware of various gaming practices. And the regulators are no doubt looking into this. 

We are certainly seeing more critics going public with more pointed comments. "They're destroying the market from which they're making so much money," Joe Saluzzi of Themis Trading in Chatham, N.J., told the LA Times. "They're like locusts. They come in, swarm the market, squeeze as much as they can, and when they're done they'll just move on to a new market." - Jim