It is hot, savvy and mysterious. It is a way for sophisticated hedge fund traders to master the stock market. It is called high-frequency trading and it is one of the most talked about, enigmatic and powerful forces in the market today.

What is high frequency trading, why is the SEC concerned about it and what should hedge funds do today to prepare for the added scrutiny?

High-frequency trading utilizes complex computer codes, called algorithms, to monitor the market for trends and to make trades immediately (in one-millionth of a second) in order to capitalize on those trends. These computer algorithms are based on the financial records of daily transactions, which include information on the price, time, size, and order of each day’s trades.

These algorithms search “dozens of public and private marketplaces simultaneously” from stocks to commodities and scan for trends. (2) Once a trend is recognized, the algorithm purchases and then sells the trending stock within milliseconds at a price sometimes just one cent higher than the purchased price.

Even though these trades might only result in a profit increase of one cent per share, these trades are made in such high volumes that high-frequency trading has become extremely profitable. More than half of all stock trading volume in the United States is through high-frequency trading, according to the TABB Group, which has estimated $21.8 billion of annual earnings in high-frequency trading. (3)

Proponents say that hedge funds and others engaged in high-frequency trading provide a constant, ever-ready flow of securities when investors need them, making trading cheaper for everyone.

When a mutual fund wants to buy 10,000 shares of Tesla, Inc, odds are a high-frequency trader will be ready to provide the shares. (4) When investors can buy a security knowing they can resell it at anytime, confidence in the market is maintained.

Others, however, have concerns.

They are critical and fearful of the practice, especially after the May 6th flash crash.

Some critics feel this kind of trading creates inequalities in the market because it allows for these traders to have a “window into the direction of the market” and provides them with an opportunity to trade on this knowledge before anyone else can. (5)

Others’ concern arises out of the perceived lack of oversight that is integral to the high-frequency trading process. For example, “naked access” trading refers to when brokers allow high-frequency traders to use the broker’s access code to trade on an exchange without supervision. Many feel this lack of oversight and control could destabilize the market. (6)

“Dark pools” are another type of high-frequency trading where anonymous trading venues allow high numbers of shares to be traded without the prices or participants being revealed until after the trades are completed. As the name suggests, many oppose these venues for their lack of transparency.

As a result, the Securities and Exchange Commission and Congress have announced their intention to probe the fairness and stability of this system of trading. The SEC announced it is looking at whether "that trading is having a manipulative effect on individual stocks or other securities," said Scott Friestad, associate director of the SEC's Division of Enforcement.

Major Wall Street players could be under heightened scrutiny by the SEC, including hedge funds. In light of the heightened scrutiny announced by the SEC, this is a critical time for hedge funds and large banks to be extra vigilant about ensuring that their compliance with current SEC regulations, processes and procedures is up to par.

What should hedge funds and other high frequency traders do?

They would be wise to engage experienced outside counsel to review their compliance policies and procedures in connection with all of their trading activities. Doing this now will go a long way in convincing the SEC that hedge funds and large banks take compliance seriously and that high frequency trading, rather than destabilize markets, is another way to facilitate the constant, liquid market of securities.

© Copyright DLA Piper

Published with permission of author.

The views expressed in this guest column do not necessarily reflect the views of HedgeFund.net.

1 The authors wish to thank Anthony Portelli, a 2010 summer associate based in the Los Angeles office, for his invaluable contributions to this article.
2 Charles Duhigg, Stock Traders Find Speed Pays, in Milliseconds, NYTimes.com (July 24, 2009).
3 Jonathan Spice & Herbert Lash, Who’s Afraid of High-Frequency Trading?, Reuters.com (Dec. 2, 2009).
4 Scott Patterson & Geoffrey Rogow, What’s Behind High-Frequency Trading, WSJ.com (Aug. 1, 2009).
5 Scott Patterson, Kara Scannell & Geoffrey Rogow, Ban on Flash Orders Is Considered by SEC, WSJ.com (Aug. 5, 2009).
6 Id.