If a machine engages in something that looks a lot like insider trading, is it illegal? Should it be?
I was talking about this with CNBC’s Eamon Javers, who broke some of the early stories about millisecond trading advantages on market-moving data releases. As he put it, if you were a broker representing a client who just ordered a large volume trade, and based on the assumption that the big trade would boost that stock’s price, you yourself traded on that information before the trade took place, you’d clearly be guilty of an insider move.
But what if it’s a machine that’s doing much the same thing? That is, it takes a few milliseconds for computer systems to coordinate a big trade over numerous exchanges. Flash traders have developed algorithms to pick up that information in even fewer milliseconds and get in on the trade before it goes through. They’re running in front of the big trade, buying shares at the presumably lower, pre-trade price.
New York State Attorney General Eric Schneiderman, a guy with both a great nose for ways in which well-placed elites game the system, and the position and energy to do something about it, has been on this case for a while now (full disclosure: he’s a friend).
Here’s how he summed this up recently:
When blinding speed is coupled with early access to data, it gives small groups of traders the power to manipulate market movements in their own favor before anyone else knows what’s happening. They suck the value out of market-moving information before it even goes public. That’s ‘Insider Trading 2.0,’ and it should be a huge concern to anyone who cares about the markets and the free flow of capital on which our economy depends.
I know Michael Lewis’s new book, Flash Boys, deals with this and I look forward to reading it (it’s staring at me across the room); I’ll be interested in what he thinks should be done about this problem. I suspect Schneiderman will prosecute the case and at least to me, it’s no reach at all to see the analogy between the clear-cut human case of using insider info and the digital case.
But wherever this lands, it provides another rationale for a financial transaction tax. In this case, the tax would internalize a negative externality—whether you view digital front-running as legal or not, it seems entirely unrelated, if not antithetical, to efficient capital allocation and wholly related to rent-seeking.