Regulators in the United States and abroad have embarked on an effort to crack down on market abuses involving computerized high-frequency trading. High-frequency trading was found responsible for the "flash crash" of May 6, 2010, and regulators suspect that it is contributing to the recent volatility observed in the markets.
High-frequency trading has become very popular, especially among large trading firms, since regulatory reforms encouraged exchanges to shift from floor-based trading to electronics several years ago. This practice now accounts for two-thirds of all trading volume on U.S. exchanges.
Critics warn that high-frequency traders fundamentally undermine the fairness of the financial system, because they make large profits at the expense of retail investors who have no access to such high-frequency trading technology. Long-term investors such as pension funds also complain that some traders may be using high-frequency trading technology to detect large buy or sell orders, and, by trading a fraction of a second ahead of large trades, take advantage of price moves. This concern is driving some large investors to move to venues away from public exchange, called dark-pools.
Domestic and overseas regulators are weighing several ideas for cracking down on manipulation by high-frequency traders. In the U.S., the Securities Exchange Commission approved a "large trader" rule in July that requires high-frequency traders to offer additional information about their activities. Some regulators have called for compulsory registration of high-frequency firms and pre-trade testing of their algorithms. The SEC has also proposed a powerful monitoring system called a consolidated audit trail that would gather data on trades in real time from all U.S. exchanges.
Institutional and retail investors concerned about market volatility should keep a close eye on regulators' attempt to keep one step ahead in this technological arms race.