Regulation Of High-Frequency Trading May Mean New Rules For All Hedge Funds

Jun 15 2010 | 11:36am ET

By Irene Aldridge, ABLE Alpha Trading -- Recently, the media has created a frenzy surrounding high-frequency trading (HFT). Various commentators have posed tough questions and they have pressured regulatory bodies around the world to respond. Many of the proposals to placate the critics of HFT have surfaced, yet few have been deemed satisfactory to all. Among the regulatory measures most popular with the critics of high-frequency trading are proposals to track transactions of all large traders, impose a transaction tax, and ban high-frequency trading outright, all in addition to the recent 10-minute “circuit breakers” the Securities and Exchange Commission adopted for selected stocks last week. 

One of these proposals, the one requiring large traders to report all transactions to the SEC, is bound to have a considerable impact on many hedge funds.  Yet, the proposal’s impact on “lower” frequency market participants is often buried in the news or overlooked altogether.  This article highlights the pros and cons of their proposals, and their intended and unintended consequences. 

One version of the proposal calls for all traders with more than $20 million in daily volume to report their transactions to the SEC. An average person, unfamiliar with the business of investment management, may surmise that $20 million is a significant hurdle for a fund or institution to transact in any given day. In reality, quite a few successful and well-capitalized hedge funds, pension funds and mutual funds may turn over more that $20 million of their equity portfolios in an effort to manage risk and maintain prudent portfolio exposure in the face of market developments. 

As a result of the proposal, even those institutions holding the pensions and 401k plans for average investors may be required to report their trading activity. In addition to the obvious cost of organizing and conducting regular reporting that will be ultimately passed down to the investors, the proposal raises an additional worry: who will be privy to this trading information and how will they use it? 

The key danger with having a centralized body, like the SEC, charged with the mandate to collect all trading activity lies in the information found in the data. The main reason large successful institutions keep their cards close to their chests is that the institutions invest considerable amounts of money to avoid generating consistent transaction patterns that often repeat themselves under specific market conditions.  By observing these trading patterns, an outside researcher with reasonable education can replicate or even fully reverse-engineer the original investment strategy used by the institution, at less than one hundredth of the cost the institution paid to generate the investment strategy.  What’s worse, the clever observer may then trade on the same strategy, diluting or even erasing the profits of the institution that invented the method, ultimately hurting end investors.  By granting the SEC staff unfettered access to one’s trading activity, the institution risks that all of its work is lost through a simple replication activity by an unscrupulous SEC staffer. 

An additional, less obvious reason for the $20-million threshold for reporting requirements may lie in the SEC’s continued push to register all hedge funds. The SEC has offered voluntary hedge fund registration for all domestic funds with over $20 million under management. Setting the $20-million trading threshold may make quite a few funds that are currently opposed to the SEC registration become indifferent to the idea. 

Irene Aldridge is quantitative portfolio manager at ABLE Alpha Trading, LTD., in New York City.  She is the author of “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems” (Wiley, 2009). 

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