Monday, July 1, 2013

SEC Investigating Early Release of Data to High Frequency Traders

By Tim Dulaney, PhD and Tim Husson, PhD

Every month at 10:00 AM Eastern time, Thomson Reuters publishes the Institute for Supply Management (ISM) manufacturing data on its website.  The ISM data is a widely cited benchmark, and its announcement can move stock markets.  On June 3, that data was disappointing, and the stock market fell in response to the news.  But it fell 15 milliseconds before the data was released.

Likewise, every month at 10:00 AM Eastern the University of Michigan publishes its Consumer Sentiment Index data through Thomson Reuters.  Five minutes before, at 9:55 AM, Thompson Reuters announces that data to its paying subscribers on a conference call.  But just two seconds before that, at 9:54 and 58 seconds, it sends that data to high frequency traders who pay a hefty additional fee for the service.

Clearly, there is an advantage to having potentially market-moving news before other traders.  But how much could two seconds possibly be worth?

Potentially a lot.  Nanex LLC, a high frequency data provider and analysis firm, has documented numerous examples of suspicious and potentially illegal high frequency trading activity.  For example, you can find their analysis of the June 3 ISM manufacturing data announcement here, which was profiled by CNBC.  They also found that trading in SPY, the largest S&P 500-linked exchange traded fund, topped 100,000 shares within ten milliseconds of the May 17 Consumer Sentiment Index early release, and that $40 million was traded within a half second.

The SEC is now investigating the relationship between ISM and Thomson Reuters, but clearly the problem extends beyond that single instance.  As noted by the New York Times:
The incident speaks to the increasing importance of speed in the nation’s stock markets. More than half of all American stock trades are now executed by firms that rely on high-speed connections to place and withdraw thousands of orders a second. In order to compete, these traders look for any leg up, including quicker ways to receive market data.
High frequency trading firms might argue that their approach is an extreme example of liquid, price-finding markets.  But Nanex has documented other examples, including the flash crash of 2010, that suggest high frequency trading can lead to unexpected market movements and perhaps even instability.  Nanex also argues that high frequency traders are liquidity takers, not liquidity providers as is often claimed.

It is not clear what tack the SEC, the exchanges, or other regulators might take in response to these trading strategies.  But it is now becoming clear that they are prevalent and can have a significant market impact.

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