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High frequency trading (HFT) is a hot topic among investors due to allegedly causing the "Flash Crash" of 2010 and last year's massive trading losses at Knight Capital (NYSE:KCG). During the "flash crash" the Dow (DJI) suddenly fell 9% or 1,000 points for no apparent reason, only to recover the losses minutes later. In the Knight Capital fiasco, a glitch in a HFT computer resulted in over $500M in losses in less than an hour.

Consequently, many individual investors and non-HFT fund managers would like to see further regulation by the SEC in this area - a result that seems likely after the presentation by the SEC. Yesterday, SEC Chairman Elisse Walter directly addressed high frequency trading regulation in her speech "Harnessing Tomorrow's Technology For Today's Investors and Markets" at American University, Washington College Of Law. I was able to attend the speech being that I am a law student at American University.

As a preface, the following represents my personal opinion and interpretation of the information presented at yesterday's speech - not that of the SEC. The official position of the SEC and Chairman Walter was not specifically stated and may be different than portrayed below.

My Conclusions And Reasoning:

1. The SEC is in favor of regulating HFT and will likely justify regulation through prior events such as the flash crash coupled with data provided by their new algorithm technology "Midas."

The new software, dubbed "Midas" by the SEC, was developed by a HFT programmer and will allow the SEC to track all market orders to buy or sell, regardless of whether those orders are filled or cancelled. Midas will allow the SEC to pinpoint specific trading techniques often implemented by HFT firms and possibly link the trades to subsequent "flash crashes" or market manipulation. Specifically, the SEC will likely use Midas technology to pinpoint and examine excessive cancellations of large buy/sell orders and certain buy/sell orders which only remain open for fractions of a second.

Conversely, Chairman Walter said the Midas software will also be used to determine the legitimacy of the claim that HFT increases market liquidity - the most common defense to the trading practice.

Overall, the tone and scope of the content presented made it apparent that it is only a matter of time before the SEC regulates HFT. For example, the presentation included how the Knight Capital trading losses and the 2010 flash crash were both due to some form of buy/sell order entry that closely resembles HFT strategies (although HFT was not directly named), but I do not recall the SEC giving an example of how HFT could increase liquidity - or anything positive about HFT, for that matter.

Furthermore, Chairman Walter reiterated a few times that one of the goals of the SEC is to level the playing field so that retail investors are not at a disadvantage or subject to market manipulation. To achieve this goal, the SEC would have to conclude that HFT does not cause market manipulation and doesn't give HFT firms an unfair advantage -- an unlikely result even absent supporting Midas data due to the flash crash and Knight Capital fiasco.

2. The SEC will regulate high frequency trading by imposing new rules regarding buy/sell order formation and duration.

Any regulation by the SEC would likely be in the form of a proactive measure which restricts certain types of buy/sell order entries. Instead of reacting to the problem (such the SEC's short-selling ban in 2008 in response to market declines) the new policy will likely prevent HFT manipulation all together.

A specific regulation possibility floated by Chairman Walter was to require that all orders remain open for a minimum period of time after being entered. This approach would help to insure that whoever enters a buy/sell order actually intends for that order to be filled. Furthermore, this proposal would eliminate certain trading practices that artificially push stocks higher by giving the impression of a significant underlying bid.

In the former scenario, a trader using a ultra-fast HFT computer will open a long position in a specific stock in conjunction with placing a large number of buy orders for the same stock, which gives the illusion of strong buying support. Next, just fractions of a second after the buy orders were entered, the computer would sell the long position profiting a few pennies from the rise in price due to the buying pressure created. Finally, the computer cancels all of the open buy orders before they are filled.

While this is just one example, implementation of the above regulation requiring buy/sell orders to stay open for a certain period of time would eliminate this problem altogether, because the buy orders would be filled before they could be canceled.

Accordingly, the overall conclusion is straightforward: investors can breath a sigh of relief because soon the possibility of a "flash crash" due to HFT will be significantly reduced due to the likelihood of forthcoming SEC regulations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Tuesday's SEC Presentation: Regulation Of High Frequency Trading Is Coming