What is the Securities and Exchange Commission? How did they contribute to making high-frequency trading easier?
The U.S. Securities and Exchange Commission’s primary purpose is to prevent market manipulation. However, when the stock market transitioned into a technological stage, they were forced to change their stock market regulations with it. Unfortunately, these regulations made it easier for high-frequency (HF) traders to exercise their power over responsible investors.
Here’s how the Securities and Exchange Commission’s regulations ended up backfiring on them and who stepped up to fix their problems, as explained in Michael Lewis’s book, Flash Boys.
The Securities and Exchange Commission’s New Regulation
As the stock market changed due to technology, stock market regulations changed with it. In 2007, the Securities and Exchange Commission (SEC) enacted a new rule that would have lasting effects on the market—the Regulation National Market System (or Reg NMS). This rule stated that traders must buy stock at the lowest market price for investors. So if stock for a company ranges from $10.00 and $10.08, the trader has to buy it at whichever exchange sells it for $10.00. Reg NMS was intended to ease investors’ worries that traders weren’t getting them the best deals.
The SEC then created the Securities Information Processor (or SIP) to make sure investors had access to the same market prices so they could abide by Reg NMS. The SIP collects the stock prices at all thirteen stock exchanges and consolidates this information into one data feed. Thus, it calculates the lowest market price so traders can follow the regulation. Both the new regulation and the new processor would change the way HF traders operated, allowing them to more quickly identify price changes at any given time.
|Pros and Cons of Reg NMS
Like Lewis, other experts are concerned about the SEC’s regulations and their impact on markets. Some experts urge the SEC to reevaluate and update Reg NMS, while others recommend a complete overhaul of their rules. While Reg NMS may have positive effects on fair pricing and market competition, critics note that the regulations have led to further market fragmentation, difficulty executing orders quickly, and less efficient prices, showing that financial experts can’t agree on the effects of the regulations. Some experts have even urged scrapping the idea of government oversight altogether and moving toward a system of self-regulation.
Additionally, the increase in regulation price visibility may explain why large investors have moved toward dark pool trading, rather than on the public markets, which would exacerbate the problems Lewis attributes to dark pools.
IEX Works to Fix What the Securities and Exchange Commission Couldn’t
Despite working to make the market fairer, the Securities and Exchange Commission has failed to regulate HFT firms promptly. Brad Katsuyama, a former Royal Bank of Canada employee, decided to take matters into his own hands by creating his own firm and regulations.
Katsuyama and his team quit their jobs at RBC to create their own stock exchange. They called it the Investors Exchange, or IEX. The purpose of IEX was to make investing fair by preventing the predatory behavior of HF traders.
Lewis believes that they succeeded—IEX ranked number one on a list evaluating exchanges on how well they adhere to trading regulations. IEX also had larger trade orders than other exchanges, as well as more random trades. So if a stock changed price in another market, IEX was less likely to execute trades because of it.
When creating IEX, Katsuyama and his team knew they couldn’t ban HFT on their exchange. But they could take preventative measures against the tactics HF traders used to exploit investors. Lewis discusses the team’s five solutions addressing each of the HFT tactics.
IEX vs. Securities and Exchange Commission
While Lewis praises IEX for fighting HFT, some critics note that in doing so, he perpetuates the idea that stock exchanges will correct themselves without regulation. Critics believe that regulating bodies like the SEC—not exchanges or traders—should be responsible for keeping up with changes in stock trading—especially for something as influential as HFT—and taking actions to protect investors. Experts have suggested a small tax on every trade, called the Tobin Tax, that would have little effect on regular investors but deter HF traders by reducing the margins they make on their frequent trades.
However, Lewis and critics seem to agree on the fact that while the Securities and Exchange Commission should regulate HFT more, they’re not—and if they are, they’re acting too slowly. In 2021—seven years after the book’s publication—the SEC began considering new mandates for HFT firms that would require them to report all of their trades and to be subject to periodic exams. Lewis praises the IEX team for their actions in spite of the SEC’s failure to do so.
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Like what you just read? Read the rest of the world's best book summary and analysis of Michael Lewis's "Flash Boys" at Shortform .
Here's what you'll find in our full Flash Boys summary :
- Why high-frequency trading (HFT) is a threat to your investments
- A look at Wall Street’s greedy response to HFT
- How Canadian trader Brad Katsuyama tried to fight the problem