Technology and Markets: Is Flash Front Running Insider Trading?

April 23rd, 2014 at 11:20 am

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.


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5 comments in reply to "Technology and Markets: Is Flash Front Running Insider Trading?"

  1. David Lund says:

    It’s not “a machine … doing much the same thing”. It’s people using a machine to do the same thing. The machine didn’t decide what kind of trading to do (or indeed whether to do any trading) on its own. Ergo it’s exactly the same as your example of a broker using information on a trade before the trade takes place.

  2. Patrick Paul says:

    I’m not terribly knowledgeable of trading systems or cryptography… but I believe you could simply envelope trade orders in encryption for specific intervals of time in the future which exceed the lowest-common-denominator’s trade latency, and match buyers with sellers as usual… and therein confer no advantage to to high-frequency traders which locate their machines closer to the exchange? If an exchange only executed trades at :00 and :30 minutes on the hour, published an encryption key in advance which was truly secret, and only accepted buy/sell orders from :01-:29 and :31-59 minutes on the hour… then anyone with a broadband connection which can review historical transactions and post new orders within a 30 minute window is on the same playing field. Obviously, you could rather opt for :XX seconds or milliseconds or … whichever interval you want but using crytography and sealed bids is not a terribly novel idea to avoid this sort of criminal activity. And certainly not my original idea. And think of how many highly paid back-office traders on Wall St could be laid off to take jobs in healthcare to actually provide tangible benefits to the social welfare of Man. The possibilities!

    • mitakeet says:

      As Patrick says, something needs to be done to level the playing field. To me it is ‘only’ proof of how thoroughly our regulatory practices have been hijacked by the monied elite that we are even having this conversation. This high-speed trading is, pure and simple, illegal, but there is so much money in it (much like the drug trade) that the ‘sheriff’ gets his payola to look the other way.

      I advocate a financial transaction tax that should put a huge damper on the people who do millions of trades every day making a fraction of a penny, though I am sure the exchanges will continue to fight that tooth and nail.

      I further advocate requiring a random delay in processing transactions so it is impossible to take advantage of your proximately to the exchange to obtain an unfair advantage.

      Not that anything I say will have the slightest impact…

  3. MBAissuesdotcom says:

    Why are we advocating a new tax? The last thing a wasteful bloated federal government needs is a new tax. I am OK with mandatory delays and other such gimmicks that remove the millisecond advantage. But another tax?

    • Patrick Paul says:

      Sometimes a tax can be more efficient than the compliance costs of regulation… A financial transactions tax would make high-frequency trading unprofitable and perhaps cost society less than the overhead involved with a new regulatory agency (and all the attendant bureaucracy) to verify and enforce “mandatory delays and other such gimmicks that remove the millisecond advantage”. The former may be a lot simpler to implement (and staff at the IRS/SEC) than the latter…. and while you would not see the tax explicitly in your stock brokerage account statements, the greater cost would creep up somewhere in the income tax burden.

      Similarly, this is why I recently came to favor a carbon tax… Cap-auction-and-trade is a very idealized miracle solution to achieving our goals of curbing emissions with a market-based solution, but in reality the bureaucracy would be unwieldy and perhaps incur a greater spend than how effective a tax could be in achieving the same nominal reduction in carbon emissions. And we wouldn’t get the idealized cap-auction-and-trade program in the first place; we would get something captured by Oil or the lobbyists working for Oil looking for another teet to draw to milk from.