Exchanges circle wagons as high frequency traders risk emasculation
By Ian Fraser
Date: April 16th, 2012
High-speed traders use powerful computers to identify orders as they emerge and instantly trade ahead of them, hoping to earn a small crust on each trade. They use complex algorithms to churn out thousands of trades, and to lesser extent orders, on multiple markets in fractions of a second. And if they can do this in huge numbers, the rewards can be immense. It’s a ‘zero-sum’ game that is being won by those trading outfits with the best computers, the smartest ‘quants’ and access to the best algos, but lost by the rest of us.
Not only is HFT legalized front-running. It is also a socially worthless activity that amplifies market movements, increases market fragility, inflates asset price bubbles, and naturally worsens market crashes. And as we saw with the ‘Flash Crash‘ of May 2010, it can also fuel market mayhem.
One of the high speed traders’ most outspoken critics is Charlie Munger, vice-chairman of the US insurance group Berkshire Hathaway. In an interview with CNN in May 2011, Munger said:
“I don’t think the rest of us have anything to gain in having massive trading between computers which try to outwit one another with their algorithms. To the extent that one succeeds, the rest of us are all paying …”
And in a speech at the Institute for New Economic Thinking’s Berlin conference on April 14, the Bank of England’s Andy Haldane said that, at best, high speed trading creates a “mirage of liquidity“:
“One reason [high frequency traders] dominate volumes is because they submit huge volumes of quotes in the market, the vast majority of which are never exercised. The firms cancel them before they are ever exercised … And currently [in the US equity market] for every order executed, 60 are cancelled. So what’s going on here?”
“One thing that’s going is that, although there are loads of quotes on the screen, if you try and hit them, they have disappeared before you can ever transact as you would wish. There is a mirage of liquidity…
“Some have said this ‘quote stuffing’ is imposing an externality, in terms of bandwidth, on slower traders … the ‘flash crash’ was no one off. In the period since, although less publicised, there have been hundreds of mini ‘flash crashes’.”
A joint report published by the Securities & Exchange Commission and Commodities Futures Trading Commission (CFTC) in October 2010 concluded that the May 6, 2010 ‘Flash Crash’ was fuelled when HFT algorithms “began to quickly buy and then resell contracts to each other — generating a ‘hot-potato’ volume effect as the same positions were passed rapidly back and forth.” In other words, the algorithms ran amok, and caused the market to tank.
Given this background, it’s perhaps unsurprising that legislators, central bankers and regulators have been looking at HFT more sceptically since the crisis. New regulations that would cramp speed traders’ style are already in the pipeline in Europe and the US. In March the Wall Street Journal reported that the SEC is investigating whether HFT firms are abusing their links with the operators of computerized stock exchanges they trade on such as BATS Global Markets, in order to manipulate markets and cheat ordinary investors.
The Journal’s Scott Patterson also recently lifted the lid on how high-frequency specialists Pipeline Trading Systems LLC and Millstream Strategy Group developed a “dark pool” licensed from Fidelity Investments, seemingly with the specific goal of fleecing the uninitiated.
Stock exchanges have much to lose from any regulatory crackdown and are desperately seeking to pre-empt one with various pre-emptive measures. The London Stock Exchange Group, Deutsche Borse and Nasdaq OMX are taking various steps to slow trading down, in the hope of persuading regulators they deserve to be allowed to continue to self-regulate. Andrew Bowley, who leads the computerised trading unit at investment bank Nomura International, told Reuters:
“The exchanges are looking to push self-regulation rather than have regulation imposed upon them.”
The LSE Group’s Borsa Italiana is introducing penalties for firms that exceed an order-to-trade ratio of 100:1, with a sliding scale of fines ranging from 0.01 to 0.025 euros per trade above that, depending on the severity of the breach. Under the Italian exchange’s new rules, firms sending 101 orders before producing a real trade each day would be punished, whereas those that have a ratio of 99:1 or less would avoid censure.
According to Investopedia, HFT gained traction in the US after exchanges like the NYSE started offering incentives and rebates to market participants such as Goldman Sachs who added liquidity to the market. The ‘supplemental liquidity providers’ rebate offered by the NYSE is in the region of $0.0015 per trade. That adds up to a stack of cash if you multiply it by millions of transactions per day. There are clearly a lot of vested interests at play here.
Given regulators’ apparent determination to root out some of speed trading’s sins, it will be interesting to see if the exchanges’ pre-emptive strikes actually work.
HFT does have some defenders, most of whom work in finance or are academics with close ties to the industry. One of their main contentions is that HFT narrows the bid/offer spread, which actually helps ordinary buy-and-hold investors. In a recent Bloomberg op-ed piece Prof Bernard S. Donefer, associate director of the Subotnick Financial Services Center at City University of New York (CUNY), stood up for the practise. He argued:
“Automated market makers (or AMMs), a subset of HFTs, are liquidity providers. Their quote-and-cancel rates may be high, but unless they offer the best price in the market, they won’t get order flow… AMM systems automatically stop trading when market data appear out of normal bounds or when regulatory capital reaches prescribed limits. These are reasonable actions.”
Donefer conceded that certain HFT practices may require further scrutiny since they may lead to market manipulation. He said regulatory responses should focus on stamping out bad practices, not cracking down on HFT per se. Joe Saluzzi of Themis Trading published a powerful riposte to Donefer’s claims, highlighting omissions in his arguments.
This article was first published on QFINANCE on April 16th, 2012
Further reading on high frequency trading and exchange traded funds:
- SEC report into ‘Flash Crash’ shows system creaking by Anthony Harrington
- The $4 trillion a day FX market keeps growing by Anthony Harrington
- ETFs’ breakneck growth makes them an accident waiting to happen by Ian Fraser
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