Intermediation Winners And Losers
"High-frequency trading systems are like vacuum cleaners. They suck nickels and dimes off the market floor all day long," said Richard Gardner, the CEO of Scottsdale, Ariz., trading software developer Modulus Financial Engineering, in a press release. 

Perhaps the most controversial aspect of high-frequency trading is that exchanges and trading centers can give traders direct data feeds and place the traders' servers physically close to the trading center's matching engine (a practice known as co-location). The combination of the two allows the high-frequency traders to quickly jump between buyers and sellers to scavenge modest per-share profits on large numbers of trades. In other words, their computers see other investors' orders before they're displayed to the market, then trade ahead.

The direct feeds contain significantly more than just the price and size information shown in the consolidated feed the rest of the market sees. The extra data includes the time stamp, the side (buy or sell), revisions, reserve orders, linked executions and more, according to a May 2010 white paper by Themis Trading, a New Jersey-based agency brokerage that trades for institutional clients and does no proprietary trading. The firm's co-head of equity trading, Joe Saluzzi, says Themis devotes a fair amount of time researching high-frequency trading "to protect its institutional clients from getting ripped off."

What really bothers him is information that allows high-frequency traders to ascertain an investor's accumulated volume in a position. "Buried deep inside these enhanced data feeds are little order IDs that attach to every order, and they give away information that institutions thought was hidden," says Saluzzi. While the IDs don't reveal the order originator's identity, they do show the number of shares a particular investor has accumulated in a certain time period.

This information allows high-frequency trading algorithms to predict price movements with virtual certainty, then profitably insert themselves between buyers and sellers and drive up investors' costs, Saluzzi argues. "The trade where you paid $27 a share, you probably should have paid $26.80 because the high-frequency trading guys were able to spot you and take advantage of you all day long." And if you were a disciplined buyer who wanted the stock at $26.80 and not a penny more, you lost an opportunity to buy.
The direct data feeds almost always reach their subscribers before the consolidated data feeds reach everyone else. Co-location puts high-frequency traders in an even better position (due to lower latency, or the amount of time it takes data to travel from the trader's terminal to the matching engine) to take advantage of the information in the private data feeds and trade ahead of other investors' orders.

"A fraction of a second is a huge advantage," Saluzzi says. "It's enough time to recalculate the national best bid and offer and take advantage of an incoming order."

The Investment Adviser Association, a trade group in Washington, D.C., says, "Investment managers are concerned that publicly revealing their significant trading interest may lead to professional traders attempting to take advantage of their investment strategy."
As far as Southeastern Asset Management is concerned, "Combining the use of direct data feeds with co-location services gives HFTs an unfair and inappropriate opportunity to detect and disadvantage long-term investors." Some call this "legalized front-running."
But Southeastern makes another important point about high-frequency trading, one that goes to the very heart of the investment profession's raison d'être. The firm said in its comments to the SEC that giving high-frequency traders a pre-public view of detailed order information is tantamount to theft of its intellectual property.

After all, an advisory firm's trading decisions represent the aggregate result of its proprietary research and analysis. "The property rights of creators of intellectual capital are being systematically and openly ignored by the exchanges and certain market participants. The order originator's hard work, ingenuity and prospective returns are being taken and sold by those who did not create it," Southeastern said.

Whose Data Is It?
As for who owns the information in the direct data feeds-order originators such as Southeastern or the exchanges-the law may not be entirely clear. Between 1905 and 1926, several U.S. Supreme Court cases examined the legal interest that an exchange had in its quotations. Comparing the quotations to trade secrets, the court said that the exchanges had a proprietary interest because of the work they put into assembling them. As the owners of the quotations, the exchanges were therefore free to sell, or refuse to sell, the quotations to anyone they chose.

But a lot has changed since the early 20th century. For instance, a direct data feed contains more than just quotations. A court could consider that fact pattern sufficiently different to warrant a different outcome today.