(Bloomberg) — Mark Gorton knows what will happen on the day high-frequency traders computers get kicked out of the New York Stock Exchange.
All youre going to do is have a data center thats across the street, said Gorton, founder of the Lime Wire LLC music-sharing service and managing director of Tower Research Capital LLC, one of the most prolific equity traders in America. Everyones going to want to put their computers there.
Gorton welcomed parts of New York Attorney General Eric Schneidermans new inquiry into speed trading, particularly its focus on preferential access to data. At the same time, Gorton says Schneiderman risks overturning years of progress by banning practices such as co-location, in which firms like Tower increase their trading speeds by placing their computers within feet of exchange data processors.
Its unfortunate that in New York City, the center of financial markets in the world, that he doesnt understand the role played by professional traders, Gorton said in a telephone interview yesterday. He seems to be upset that there are computers in markets.
Schneiderman is examining the sale of products and services that offer faster access to data and richer information on trades. Wall Street banks and rapid-fire trading firms pay thousands of dollars a month for these services from firms including IntercontinentalExchange Groups NYSE and Nasdaq OMX Group.
During a panel discussion yesterday following Schneidermans speech, Chad Johnson, chief of the New York Investor Protection Bureau in the attorney generals office, said his boss doesnt pine for the days before electronic trading, and recognizes there were issues in the past.
The focus of our initiative is on the abusive practices, the latency arbitrage and the like, Johnson said yesterday. The strategies are ultimately extracting from the capital markets enormous sums of money and not providing benefit that makes that worthwhile, he added. You dont necessarily have to get rid of the bad and toss the good — if there is good — at the same time.
At issue is a model that regulators have permitted for years. Firms pay to place their systems in the same data centers as the exchanges, letting them directly plug in their companies servers and trade thousandths or even millionths of a second faster. They also purchase proprietary data feeds, which are faster and more detailed than the stock-trading information available on the public ticker.
Gorton has found himself at the intersection of technology and the law in the past. In 2011, he and Lime Wire settled for $105 million a lawsuit pursued by Warner Music Group Corp., Sony Corp. and other music label owners. The music companies claimed Lime Wire induced copyright infringement on thousands of songs.
While Lime Wire is the invention that hes most famous for, Gorton, an electrical engineer with degrees from Harvard, Stanford and Yale, is also a pioneering high-frequency trader, running Tower Research in New York. Another firm he founded, Lime Brokerage LLC, was sold to Wedbush Inc. in 2011. One of Towers units, Latour Trading, accounts for 1.5 percent to 2.5 percent of U.S. volume, according to data compiled by ModernNetworks IR, which advises public companies on trading.
High-speed traders see themselves as the descendants of the human market makers who used to gather on exchange trading floors to facilite transactions.
Thats a smokescreen, according to Schneiderman, whose staff has discussed his concerns with executives of Nasdaq and NYSE and requested more information, according to a person familiar with the matter, who asked not to be named because the talks were private.
This new breed of predatory behavior gives a small segment of the industry an enormous advantage over all other competitors and allows them to use new technologies to reap huge profits based on very, very minor, but nonetheless unfair, advantages, Schneiderman said yesterday during a speech at New York Law School. He said he looked forward to working with other regulators on the issue, while saying his office would keep looking for unseemly practices.
Computer-driven trades can be executed in about 300 microseconds, according to one study. At that speed, more than 1,000 trades can be made in the blink of a human eye, which lasts 400 milliseconds. At their peak, algorithms shot out about 323,000 stock-trading messages each second in the U.S. last year, compared with fewer than 50,000 for the busiest period in 2007, according to data from the Financial Information Forum.
Concern about the role of high-frequency firms ballooned after the stock market crash on May 6, 2010, when the Dow Jones Industrial Average plunged almost 1,000 points in a matter of minutes. Since then, the two main market regulators in the U.S., the Securities and Exchange Commission to the Commodity Futures Trading Commission, have carried out multiple investigations. Some of the attention is based on the industrys profits, Gorton said.
A lot of this is based on the fact that professional traders make money trading, he said. Certainly, were not long-term investors, and we dont have a diversified portfolio stocks and we dont read annual reports. Thats not what we do. What we do is we facilitate transactions so that long-term investors can efficiently execute their orders.
One of the biggest high-frequency firms, Virtu Financial Inc., publicly released its filing for an initial public offering this month, revealing that it earned money on every day but one during the past five years. New York-based Virtu also said the CFTC is examining the companys trading from July 2011 to November 2013, looking at our participation in certain incentive programs offered by exchanges or venues. Virtu said it doesnt believe it broke any laws or CFTC rules.
Market maker privileges have been a hallmark of equity trading, starting with the sale of seats to brokers on exchange floors. LaBranche & Co., created in January 1924, said in papers prepared for its 1999 initial public offering that it regularly turned about 71 percent of sales into profit before paying its managing directors. Earnings before that expense climbed at least 25 percent every year from 1995 through 1999.
Results like those, as well as concern that NYSE and Nasdaq were too powerful, helped spur reforms. Since 2000, U.S. stocks have traded in minimum price increments of a penny, pressuring market-making profits. A broad overhaul known as Regulation NMS lowered barriers to trading by mandating that an order must be sent to whatever market has the best price at a given moment. There are now more than 50 exchanges and other venues where U.S. stocks change hands.
Its true that grandma is not putting a computer in the data center to execute her orders, Gorton said. But when she routes her orders through a brokerage firm, that firm has an order and now actually the computer at the brokerage firm and the computer of the professional traders are on an exact level playing field.
The playing field wasnt always so level, said Dan Weaver, a finance professor at Rutgers University.
Since the New York Stock Exchange started in 1792, some people have paid extra to be able to get information before other people, Weaver said during an interview yesterday. Before NYSE went public and trading was done physically, people paid millions of dollars to have a seat on the NYSE so theyd be co-located next to where all the information was occurring: right on the floor at the posts.