Watchdog investigates ‘Flash Boy’ traders over rip-off concerns

 

Deputy Business Editor

City regulators are finally launching an investigation into how so-called “high-frequency traders” allegedly gain a jump on traditional pension funds and other investors.

Weeks after US regulators began to investigate, the Financial Conduct Authority has said it will look into the way such traders game the system by locating computer servers as close as possible to exchanges’ trade-matching systems.

Shaving a few metres off the length of a cable between the traders’ buying and selling IT and the exchange can allegedly mean high-frequency traders, who buy and sell huge quantities of stock within milliseconds, get a quicker, better price than the rest of the market.

The issue was highlighted by the journalist and former trader Michael Lewis in his blockbuster book Flash Boys earlier this year. Flash Boys purported to expose how traditional pension and insurance funds, investing money on behalf of ordinary people, were being ripped off because specialist high-frequency, or “flash”, traders were gaining milliseconds of prior knowledge of their orders. This was, the book argues, because their computer systems were ahead of the queue when exchanges were transmitting valuations.

The FCA is investigating whether co-location of trading IT in the same building as exchanges is skewing the market – in effect delaying the prices available to other investors not in on the trick.

Particularly, it said, it was examining “if the availability or cost of the co-location creates a barrier to entry for new market participants”.

The regulator takes pains to point out that it is not seeking to prevent traders putting their trading kit next to the exchanges’, but that it wants to make sure there is a “level playing field” for all users: “These concerns do not attempt to curb co-location activity; rather, they aim at ensuring that access to services is fair and service levels are consistent among the participants.”

The regulator was particularly keen to explore details of how much exchanges charge for newcomers to co-locate their servers.

The “Flash Boys” aspect was one part of a widespread review launched by the FCA into the way the wholesale trading markets work.

Christopher Woolard, director of policy, risk and research at the FCA, said: “Effective competition within the wholesale sector can lead to an increase in institutional efficiency, lower prices, greater innovation and can improve the quality and range of financial services provided.” This would mean better prices for consumers, he added.

Investment banking, asset management and corporate banking are also up for questioning, the FCA added.

It is concerned about how investment banks offering multiple services will try to maximise the “share of the customer’s wallet” by cross-selling, and bundling services together. This can be problematic where a bank prioritises the more profitable element of the work – such as takeover advice – at the expense of the quality of other bundled-in services such as independent investment advice. Problems can arise where customers find it impossible to work out how much they are paying for each individual service.

Also, businesses specialising in just one service – such as an independent financial research operation – can find it difficult to compete against the bundled operators, because they cannot prove their service offers better value.

Other areas up for debate are the charges banks levy on companies for flotations.

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