In most brokerage firms, there is a glass room – affectionately known as “the bubble” – which exists to separate the order room from the rest of the firm. Back when large block orders were phoned into order room and worked by specialists on the floor of the exchange, there was a very real need for physical barriers between traders working the orders and others in the firm. The prevention of front running has always been a problem, will always be a problem, and, quite honestly, was much more pervasive in the days before decimalized and electronic trading. Now, with compliance programs and employee monitoring programs, the level of scrutiny and detection is much higher, although far from perfect.
With recent renewed attempts to malign high-frequency traders (HFTs) for their aggressively opportunistic behavior that exploits gaps in market structure to make money, the issue of front running has earned a new level of visibility. Some feel that HFTs are valuable market participants who add liquidity and thus should be allowed to make (and lose) money just like any other trading entity. However, since HFTs are not designated market makers, they have no obligation to stand in the trenches and trade in down markets. What I find really disconcerting about HFTs is not their business model but rather the lengths to which they have gone – the legality of which is to be determined – to ensure they stay one step ahead of buy-side participants. The HFTs have bought high-speed access by forming special relationships with alternate trading venues which buy-side participants don’t have and can’t negotiate due to their volume.
HFTs and ATSs would have us believe that their cozy relationship is in no way a violation of market structure rules. I think the jury is still out. The NY Attorney General has taken an aggressive posture on HFTs and just yesterday issued subpoenas to several firms. Providing prioritized access to order flow prior to refreshing the NMS quote would seem to violate several sections of Reg NMS including the Order Protection Rule and Access Rule. Front running is front running – regardless of whether it’s done in hours, minutes or microseconds. What we need is the modern day equivalent of “the bubble,” a virtual one, not glass. Whether that means placing miles of fiber between ATS servers and the exchanges to “slow down” the pace of trading, or new trading venues that exclude the bad actors, something must be done to ensure the good actors in the market are protected in a way that preserves confidence and integrity.