10.04.2016

High-Speed Traders Fear Regulator Spilling Their Biggest Secrets

(this article originally appeared on Bloomberg)

Some of the biggest electronic traders are complaining that a new test in the U.S. stock market will compromise their top-secret strategies, one of their most valuable assets.

Citadel Securities and KCG Holdings Inc. are among a chorus of brokers questioning elements of a U.S. Securities and Exchange Commission experiment, which began Monday, designed to whip up more trading in small companies. Their complaint is that the test will force firms to publicly expose detailed trading data with only the thinnest veil of anonymity, allowing competitors to reverse engineer how their prized trading algorithms work.

For high-speed trading firms, complex computer code is the secret weapon for profiting from the market. Some brokers say they fear that in their test, regulators won’t sufficiently mask their publicly reported trading data.

“It’s going to take someone exactly three seconds to figure out who’s who,” said Jamil Nazarali, head of execution services at Citadel Securities, which is the market-making arm of billionaire Ken Griffin’s Citadel LLC. Trading firms will “likely change their behavior to protect their intellectual property,” making the test’s results less meaningful, he added.

The SEC declined to comment.

The plan, approved last year, requires traders to report data on how they handle stocks involved in the program, to help gauge the test’s success.

Regulators will publicly report monthly data on trading of tick pilot stocks. Though the data will be reported anonymously, some broker-dealers argue it will be easy for a shrewd competitor to identify which firm’s data is which, providing a window into their strategies.

Doug Borden, co-head of equities client market-making at KCG, said that besides exposing aspects of his firm’s own proprietary strategies, the data could be a tip-off to the trading positions and intentions of their clients, who enlist KCG’s help executing trades.

Exposing Orders

“Our main concern is it exposes our client orders,” said Borden. On top of those fears, he said, “our own strategies or vulnerabilities in the way that we trade” could be detected from the test.

Industry groups have voiced similar concerns. The Financial Information Forum sent a letter to the SEC in August, warning that distributing such detailed information, even using “dummy IDs” to mask individual brokers, could harm investors and expose trading strategies.

“All market participants will be harmed and the goals of the Pilot will be undermined if the risk of information leakage, particularly with the least liquid pilot stocks, deters firms from trading the securities,” the FIF wrote.

Still, not all major traders are sweating the data dump. Doug Cifu, chief executive officer of electronic trading firm Virtu Financial Inc., said that he’s doubtful a competitor could detect the fine points of a firm’s strategy based on the tick pilot data.

‘I’m Skeptical’

“There’s so much noise in the market,” Cifu said. “I’m skeptical that someone could reverse engineer with precision how participants are trading.”

Haoxiang Zhu, assistant professor of finance at the MIT Sloan School of Management, said while he understands why some in the industry may not want the information to be made public, worries about confidentiality may be overblown.

“I just don’t see how the tick-size pilot, in the way the additional data is collected, would kind of reveal or tip-off this proprietary information,” Zhu said. “It seems to me that this data is really kind of ideal once it’s collected for studying how the tick-size pilot effects liquidity and market-making behavior.”

This is not the first time brokers have done battle with regulators to safeguard their algorithms. Proprietary trading firms lambasted the Commodity Futures Trading Commission for proposing that they offer up their source code so regulators can diagnose the cause of market meltdowns.

Loving Data

“As an academic, I love data,” said James Angel, a finance professor at Georgetown University in Washington. “I want everything to be given to me in machine-readable form so I can analyze it.”

Nonetheless, proprietary traders aren’t off the mark in looking to guard their strategies, he said. “I can understand their hesitancy,” he said. “People have a right to privacy of their own intellectual property.”

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