On July 5, 2011, the Consolidated Quote System (CQS) used by the U.S. Stock Exchanges, increased its quote capacity by 33 percent to 1 million quotes per second. This capacity was quickly filled by high frequency trading robots (HFT's). HFT's make the old game of "quote stuffing" seem like amateur hour.
What is quote stuffing? The practice of quote stuffing is where large numbers of orders to buy or sell are offered at the exchanges such as the NYSE or NASDAQ and then canceled almost immediately. In a study released by Nanex where they did an exhaustive analysis of the Flash Crash of 2010, it was reported that there were high frequency trading robots sending as many as 5,000 offers to buy and sell for all of the large cap stocks to the exchange every second. In many cases, the offers were well outside the normal range. Here it is a year later, and the Securities and Exchange Commission, (SEC) has now expanded quote limits by 33%. It is as if the SEC failed to learn any lessons from a year ago.
Why would HFT's be so keen on quote stuffing? Say you could post a number of offers to buy (bids) and sell (asks) at various prices, even outside the normal bid/ask range. Now your competitors (institutional traders, other robots) must take into consideration the offers you posted when they make their own offers to buy or sell. They can't tell if your offers are fake and are going to be cancelled immediately. You on the other hand, can ignore the offers outside the normal bid / ask range since you created them. Now you instantly gain an advantage over the other institutional traders and robots.
What about the retail customers, the smaller investors? Bottom line...the retail customers are shredded. Retail customers haven't a clue which bids and asks are true and which are fake. Yet these customers live and die by watching the offers to buy and sell on their trading platforms. When robots stuff the out of the money bids and asks with fake offers, retail customers simply cannot adjudicate whether the Market is going up or down. This is tantamount to their "trading blind and naked."
The situation with quote stuffing is very similar to what we all face every day with spam emails. There are so many spammed emails clogging up legitimate internet backbones. Spam emails cause bottlenecks in the system, requiring more and more infrastructure to be put in place to handle more and more spam. While additional internet backbones can be installed to handle spam, for exchanges such as the NYSE and NASDAQ, this is not so easy. There are limitations. They cannot simply add "more backbones." If HFT's continue to fill the Consolidated Quote System to maximum capacity, eventually the entire market will shut down.
What is interesting to note is that in Europe, there are real limitations to the number of offers to buy and sell per day that can be sent by any one trader, and it is monitored quite heavily, by ip address, brokerage account, etc. This stops quote stuffing and allows real trading to occur. Hopefully, since the NYSE is moving to Europe, the game of spamming the exchanges with fake offers to buy and sell may come to a grinding halt.
Here's the other problem with quote stuffing. Theoretically, this practice is illegal. However, the only enforcement group is the SEC. With the passage of the Dodd/Frank bill in the Democratic Congress, the SEC was given more responsibility to oversee trading by brokerages, hedge funds, HFT's etc. With that also came a larger budget. But when the Republican Congress took control in 2010, funding for the SEC was cut. The agency's budget was due to rise $200 million but because of cuts to discretionary spending, there has been no additional funds. Without funds, the SEC cannot monitor HFT activities. What makes cutting SEC investigative powers so absurd is that the SEC is one of the only agencies that does not cost taxpayers any money.. It actually brings in revenue from fees assessed on Wall Street firms for violations and infractions. SEC Chairwoman Mary Schapiro had expected to hire 800 officials to beef up its investigative role. Now all that is on hold.
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