By Irene Aldridge

Recently the media has created a frenzy surrounding high-frequency trading (HFT).

Various commentators have posed tough questions and they have pressured regulatory

bodies around the world to respond. Many of the proposals to placate the critics of HFT

have surfaced, yet few have been deemed satisfactory to all. Among the regulatory

measures most popular with the critics of high-frequency trading are proposals to track

transactions of all large traders, impose a transaction tax, and ban high-frequency trading

outright, all in addition to the recent 10-minute “circuit breakers” the SEC adopted for

selected stocks last week.

One of these proposals, the one requiring large traders to report all transactions to

the SEC, is bound to have a considerable impact on many hedge funds. Yet, the

proposal’s impact on “lower” frequency market participants is often buried in the news or

overlooked altogether. This article highlights the pros and cons of their proposals, and its

intended and unintended consequences.

One version of the proposal calls for all traders with more than $20 million in daily

volume to report their transactions to the SEC. An average person, unfamiliar with the

business of investment management, may surmise that $20 million is a significant hurdle

for a fund or institution to transact in any given day. In reality, quite a few successful and

well-capitalized hedge funds, pension funds and mutual funds may turn over more that

$20 million of their equity portfolios in an effort to manage risk and maintain prudent

portfolio exposure in the face of market developments.

As a result of the proposal, even those institutions holding the pensions and 401k plans

for average investors may be required to report their trading activity. In addition to the

obvious cost of organizing and conducting regular reporting that will be ultimately passed

down to the investors, the proposal raises an additional worry: who will be privy to this

trading information and how will they use it?

The key danger with having a centralized body, like the SEC charged with the mandate

to collect all trading activity lies in the information found in the data. The main reason

large successful institutions keep their cards close to their chests is that the institutions

invest considerable amounts of money to avoid generating a consistent transaction

patterns that often repeats itself under specific market conditions. By observing these

trading patterns, an outside researcher with reasonable education can replicate or even

fully reverse-engineer the original investment strategy used by the institution, at less than

one hundredth of the cost the institution paid to generate this investment strategy. What’s

worse, the clever observer may then trade on the same strategy, diluting or even erasing

the profits of the institution that invented the method, ultimately hurting end investors.

By granting the SEC staff unfettered access to one’s trading activity, the institution risks

that all of its work is lost through a simple replication activity by an unscrupulous SEC

staffer.

An additional, less obvious reason for the $20-million threshold for reporting

requirements may lie in the SEC’s continued push to register all hedge funds. The

SEC has offered voluntary hedge fund registration for all domestic funds with over $20

million under management. Setting the $20-million trading threshold may make quite

a few funds that are currently opposed to the SEC registration become indifferent to the

idea.

Irene Aldridge is quantitative portfolio manager at ABLE Alpha Trading, LTD., in

New York City. She is the author of “High-Frequency Trading: A Practical Guide to

Algorithmic Strategies and Trading Systems” (Wiley, 2009). Click here to register for a

complimentary webinar with Irene Aldridge on the latest developments in high-frequency

trading. (Link: http://bit.ly/auMDiy)