To Regulate Rapid Traders, S.E.C. Turns to One of Them

RED BANK, N.J. - As billions of shares course through the stock market each day, investors rely on the government to keep up with Wall Street's rapid-fire traders.

But in an acknowledgment that the has fallen behind the firms it regulates, the agency is turning to one of those high-frequency traders for help.

Tradeworx, a 45-person firm based in New Jersey, will dispatch its experts to Washington this month to tutor regulators on a sophisticated computer program that will give the S.E.C. its first real-time window into the stock market - something firms like Tradeworx have had for years. The S.E.C. program, designed by Tradeworx, is set to go into operation at the end of this year.

The program, called “Midas” by the S.E.C., is part of a broader effort at the agency to monitor the proliferation of new technologies and to crack down on practices that have given sophisticated traders an advantage over ordinary investors. The agency recently hosted public meetings on computerized trading to examine some of the recent failures in the market, like the malfunction at Knight Capital that wreaked havoc on stock prices in August. Last week, the Nasdaq exchange had to cancel errant trades after a technical problem caused shares of Kraft to soar.

The S.E.C.'s rudimentary technology has hobbled its ability to untangle these events and police the firms. With the Tradeworx program, the agency will gain access to every bid to buy stocks and every offer to sell shares on each of the nation's 13 public exchanges. The system, akin to an X-ray machine for the stock market, could enable regulators to detect whether trading firms are overwhelming the market's plumbing when they rapidly submit and cancel orders.

“The average person on the street thinks that the S.E.C. has these massive computers that all orders are going through,” said Gregg Berman, the agency official leading the effort. “That has not been the case, but we hope to now have that with this new system.”

Some industry experts have said that the Tradeworx program is the quickest and, at a cost of $2.5 million this year, the cheapest way for the agency to catch up with the high-speed trading industry, which has gone from being a niche player a decade ago to being responsible for more than half of all trading in American stocks today. But the initiative raises a new set of questions about whether the industry is the best source for unbiased information about the markets.

David Lauer, a former employee of other high-speed trading firms, wrote in recent testimony to a Senate subcommittee that the Tradeworx program was “reminiscent of the fox guarding the hen house.”

“You don't rely on the subject of your study to build the device you are going to be studying them with,” Mr. Lauer said in an interview after the hearing.

The S.E.C. said it sought out other bids and even considered building its own database, an effort that would have taken several years and cost millions of dollars more than the Tradeworx project. Mr. Berman added that the agency looked to Tradeworx only for data feeds that were the same no matter who provided them.

The chief executive of Tradeworx, Manoj Narang, argued that if he sold bogus data to the government, it would be obvious. More important, he said, the S.E.C. has few alternatives.

“Where else are they going to be able to get these capabilities?” Mr. Narang said. “They are not available from anywhere other than high-speed trading firms. We're the only ones who possess it.”

Today, the S.E.C. relies on the official trading record, known as the consolidated tape, which includes the price of every trade executed on any of the nation's stock exchanges. Most sophisticated trading firms bypass the official record by buying data directly from the exchanges. The firms compile a full record milliseconds before the consolidated tape is assembled and obtain a wider range of information, including orders that are submitted but never executed.

Mr. Berman said that data from Tradeworx would be used throughout the S.E.C., from the enforcement division looking to catch wrongdoing to the division of trading and markets that keeps daily watch over the markets. The data could allow the S.E.C. to analyze claims that some firms take advantage of their faster data feeds to jump in front of slower traders, and complaints that sophisticated traders can jam the system with so many orders that it slows down trading for others.

Mr. Berman, a former hedge fund co-manager and nuclear physicist, led the agency's examination of the flash crash of 2010, when the Dow Jones industrial average plunged 5 percent in five minutes and then mostly recovered. He is now leading the broader effort to bring the S.E.C. into the modern world of trading. As the agency falls further behind, he is helping to build a new Office of Research and Analytics, which is looking to hire people with experience on Wall Street and in computer programming. The agency is also moving closer to creating a so-called consolidated audit trail, which will allow regulators to see the identity of the firm behind every trade.

But any future efforts depend on the S.E.C. having access to the sort of basic data that Tradeworx will provide.