Fraud at the Speed of Light

Yesterday we examined the amount of money involved in capital markets and the SEC’s resources to enforce the law. Today we want to look at an aspect of those markets that makes regulation in this area different than dealing with other types of fraud, especially in the historical context of regulating financial exchanges.

In 1933, after a month of runs on banks President Franklin Roosevelt declared a Bank Holiday and the banks closed from March 6-13.  It worked, but the time it took to make money move was different then.

In 1998, the SEC approved automated trading, so the technology to make trades faster than humans can speak is now twenty-five years old.

High-frequency trading programs can now execute a trade in less than 10 milliseconds and can execute arbitrage matching orders many times within a one-second retail execution.  That’s each new trade happening at least fifteen times as fast as human beings can react to a stimulus, according to Scientific American.

This creates more information, more liquidity in the market, and a structure for trading that is growing in capacity, which is generally what these markets need. 

The SEC reports that securities markets are now dependent on automated trading:

The equity markets are also highly complex, with dozens of different order types, a multitude of market connectivity options, and a rich array of market information products providing data in speeds often measured in microseconds. This data is the key input into the wide variety of algorithmic trading strategies that rapidly submit orders across venues, creating and moving the prices of securities, which, in turn generate more data that drives the next set of algorithmic trading decisions.

See SEC Staff Report, p 7.

The structure of this market is also more centralized, despite many different computerized trading facilities:

While there are now fifteen registered national securities exchanges for equities, and thirteen equities exchanges operating, twelve are owned by three corporate entities, commonly known as “exchange families… Trading and communication at national exchanges are now almost entirely automated.

See SEC Staff Report, p. 12.

Of course, these markets are prone to fraud, just as is any human activity. Fraud is committed by humans, but the data in securities markets is now generated by machines in volumes that require heavy computer power to track. The SEC adopted the appropriately named MIDAS system in 2013 to review the greater volume of data generated by these markets.

Every day MIDAS collects about 1 billion records from the proprietary feeds of each of the 13 national equity exchanges time-stamped to the microsecond. MIDAS allows us to readily perform analyses of thousands of stocks and over periods of six months or even a year, involving 100 billion records at a time.

SEC on MIDAS system.

The SEC continues to track the structure of these markets and attempts to ensure they are fair to investors while also allowing for adequate liquidity access to money and the ability to make trades and contracts at high speeds is a boon for business and investors.

But speed can kill.

In yesterday’s blog we asked if the 50 additional full-time enforcement positions proposed by the SEC will be enough, given the number of disclosures currently being provided to the Commission. Today we revisit the fundamental question of resources based on the new structure of these markets.

 The total FY 23 budget for the SEC included 4,609 full-time positions and $2,189,815,000 in funding, according to the recent SEC Budget Justification pp 12-13. Add to that the FDIC budget of a bit more than $2.4 billion, which helps prevent bank failures, and the total for both agencies is about $4.6 billlion annually. That is still less than one-fourth of the $18.9 billion in equity traded on the New York Stock Exchange every single day.

Given the speed at which these transactions are now clearing, and the small (in relative terms) budgets of the agencies assigned to police them, it is clear that catching any fraud occurring in these markets will require the help of whistleblowers, who know first-hand which trades are tainted by falsity or deception. Stopping fraud that occurs at the speed of light takes people willing to report that fraud just as quickly.

Tony Munter heads the Whistleblower Reward Practice at Price Benowitz, LLP