Watchdogs ask Wall Street for algo secrets

US securities regulators have taken the unprecedented step of asking high-frequency trading firms to hand over the details of their trading strategies, and in some cases, their secret computer codes.

The requests for proprietary code and algorithm parameters by the Financial Industry Regulatory Authority (Finra), a Wall Street brokerage regulator, are part of investigations into suspicious market activity, said Tom Gira, executive vice president of Finra’s market regulation unit.

“It’s not a fishing expedition or educational exercise. It’s because there’s something that’s troubling us in the marketplace,” he said in an interview.

The Securities and Exchange Commission (SEC), meanwhile, has also begun making requests for proprietary algorithmic trading data as part of its authority to examine financial firms for compliance with US regulations, according to agency officials and outside lawyers.

The requests by SEC examiners are not necessarily related to any suspicions of specific wrong-doing, although the decision to ask for it can be triggered by a tip, complaint or referral.

According to interviews with attorneys, traders, industry executives and regulators, the unusual requests for algo code and other computerised trading strategies really ramped up this year and have targeted stock-trading firms such as broker dealers and hedge funds.

It has alarmed some traders who are afraid their ‘secret sauce’ — intellectual property sometimes developed over years and at great cost — could get into the wrong hands, especially when SEC and Finra examiners leave for the private sector.

“I’d be disappointed and upset” if they asked for code, said a high-frequency trading firm executive who declined to be named. “I mean, are these people all going to work at the SEC forever?”

The SEC’s new focus on algo strategies will likely help inform any new structural rules the government agency applies to an electronic market, criticised by some as unstable or unfair, especially after the ‘flash crash’ on May 6, 2010.

While anything the regulators find could lead to legal action such as market manipulation suits, Finra’s effort appears more targeted at wrong-doing.

Finra, which reports to the SEC, usually focuses its requests on flawed codes in an effort to better understand how they are constructed, operate, and how they are supervised, Gira said. An unusually large wave of orders for a lightly traded stock, for example, could lead to a request, he said.

Trading code is a high-stakes secret for high-frequency firms that battle each other to earn razor-thin profits on tiny price imbalances in the market. Such firms can make thousands of trades per second and provide much liquidity to the market.

High-frequency trading is estimated to be involved in more than half of all US stock trading. Regulators have said the algos behind such trading were a factor in the flash crash, but that they did not cause it.

Carlo di Florio, who heads the SEC’s Office of Compliance, Inspections and Examinations, said the agency started asking firms for proprietary algorithmic trading data over a year ago, and has since more broadly incorporated such requests into its risk-based exams.

Most of the algo-related requests, he said, have been made to hedge funds that use quantitative trading strategies.

An industry attorney said that FINRA and the SEC have also been asking firms specifically how their algos react to different market conditions, and what data feeds they use.

“They’ve certainly taken this to the next level,” the attorney said.
Even though the SEC believes it needs this algorithm information to help it police the market, many on Wall Street are still not convinced the agency will know what to do with the data.

“Let’s just say the good developers in the industry are being hired by the industry — not by an SEC salary,” a trader said.