The Securities and Exchange Commission this week said it’s in the early stages of a major examination into the operations of hedge fund companies and investment banks that engage in high-frequency trading.

Carlo Di Florio, director off the SEC Office of Compliance, Inspections and Examinations, told On Wall Street that the regulatory agency has hired several experts -- “people with PhDs in mathematics” or other expertise -- to examine, in depth, the whole practice of trading stocks using computer programs and algorithms.

He said the commission’s request for proprietary data from trading companies was not a “fishing expedition,” adding that, “this is not a one-off examination. We are going to be taking a closer look into what risks are posed by this kind of trading activity.”

Di Florio also said the SEC began asking some trading companies for their proprietary algorithmic trading data as long as a year ago, and that it is now more broadly incorporating such requests into its examination process. He said requests for actual proprietary codes have been rare to date.

The expanded examination effort by the SEC, which is being undertaken simultaneously by the Financial Industry Regulatory Authority (FINRA), was prompted by events like the Flash Crash of May 6, 2010, when the Dow Jones Industrial average plunged by more than 1,000 in a just a few minutes -- in part because of computer programs that reacted --or overreacted -- to one large market order by one trading firm.

Both FINRA and the SEC are “asking” firms that engage in computer trading to provide them with their algorithms, computer codes and trading strategies, information that these companies zealously guard as trade secrets.

While the requests by the SEC seek voluntary compliance, agency examinations are part of the SEC’s mandate and its “requests” actually are more like demands. If rejected, examiners have the ability to subpoena the information.

Di Florio said the agency is handling the information it receives with extreme care and security precautions.

Both FINRA and the SEC stress that they are not investigating any wrongdoing in their examination process, but are concerned about the increasing use of computerized, high-frequency trading, and its impact on the operation of markets.

Also, they want to understand how the system could be gamed. A big concern would be if traders could induce a flash crash or a sudden rise in a market or index and then profit from it thank to their advance information that it would occur. 

That said, FINRA reports that some of its requests for proprietary code and algorithm parameters are already part of ongoing investigations by the self-regulatory agency into suspicious market activity.