REGULATORS CONTEMPLATE SLAMMING THE BRAKES ON HIGH-FREQUENCY TRADING
- It never was supposed to be this fast and furious.
When the first Wall Street traders hooked up their own personal
computers (most likely IBM PCs or early IBM clones from Compaq), the
machines were going to make things faster and easier -- more
efficient, in other words. But soon, affordable networking cards
attached the PCs to one another and then to the capital markets.
In the late 1990s and early 2000s, Wall Street went digital, and
electronic trading exploded. Add in high-speed processors, low-latency
networks, truly electronic trading platforms and dark pools, and the
high-frequency future of trading had arrived.
But executing near the speed of light can be dangerous. Along with
fast trades often have come loose control and severe crashes.
The majority of today's trades are executed electronically using
algorithms; some estimates say algorithmic trading comprises as much
as 74 percent of all stock trades in the United States -- and at
faster speeds than once were imaginable. In the time it takes you to
say "high-frequency trading," millions of shares in dozens of markets
across the globe have changed hands. But a hyperefficient mechanism
that is free of human interference, and therefore error, the current
market is not.
Exceeding the Speed Limit
Regulators including the U.S. Securities and Exchange Commission and
the Commodity Futures Trading Commission are struggling to keep up
with and keep a grip on this warp-speed world -- and they are
considering some severe measures as they struggle to understand just
what high-frequency trading is. In a speech in February at New York
Law School, CFTC commissioner Scott O'Malia admitted that his agency
has failed to keep pace with the rapid evolution of trading
technology.
This became apparent after the 2010 Flash Crash, when, O'Malia said,
he realized the group lacked a fundamental understanding of the new
trading patterns being used in the markets. "There was no consensus on
what constituted automated trading, what constituted algorithmic
trading and what constituted HFT," he told the audience. "There was no
consensus on how each type of trading affected our markets. It was
like having no consensus on what constitutes a broken window."
According to Mark Fickes, a former SEC senior trial counsel and
currently an attorney with BraunHegey & Borden in San Francisco, the
SEC is working to make sense of the new trading landscape. But it
won't be cheap or pain-free, he says.
"One of the things that is most interesting, just based on the
astronomical costs, is the proposal for the Consolidated Audit Trail,
or CAT, that the SEC has been floating for a couple of years," says
Fickes, referring to the real-time market data surveillance system.
SEC chairwoman Mary Schapiro, who proposed the CAT initiative to
Congress in May 2010 shortly after the Flash Crash, reported a
staggering price tag for the system: about $4 billion to build and an
additional $2 billion annually to maintain. "The SEC has been
deliberately vague on the issue," Fickes notes.
The CAT proposal is further proof that the fallout of the 2010 Flash
Crash and the collapse of MF Global is still reverberating throughout
the industry. "Clearly what you are seeing is government regulators
publicly acknowledging that there is a problem," Fickes says.
The HFT Debate
Although HFT has matured in the past decade, there are still
fundamental arguments around what it is and what it does. At what
speed does algorithmic trading become high-frequency trading? Did HFT
cause the Flash Crash? Can traders possibly slow down now? And perhaps
most important, is it safe?
Supporters of high-frequency trading wave the banner that they provide
liquidity to a market that desperately needs it. Critics say HFT
liquidity only drives volatility.
HFT may be a capitalistic pursuit that provides liquidity, but, "When
you peel the onion, there is a flaw in the argument," says Michael
Jenkins, a partner with global management consultancy A.T. Kearney.
"High-speed trading leads to very high degrees of market
fragmentation. Liquidity is only valuable when it can be aggregated
and aggregated in a space where there's very high transparency and
regulation that allows capital and ideas to trade freely." This is why
we have high profile exchanges located in major cities, such as New
York, London and Tokyo, he adds.
HFT is the opposite of that, Jenkins continues. "When we are down to
the microsecond level -- one millionth of a second -- where we are
now, traders hit a million markets every second, and this causes high
degrees of fragmentation, which is the opposite of liquidity."
Garret Nenner of Momentum Trading Partners, a high-touch, agency-only
broker-dealer that focuses on equities and options execution, also
discounts HFT liquidity. "If you look at the HFT firms, you see a lot
of prices are going in and they are testing the market. Those bids and
offers are not real. They are real for the microsecond they are up
there, but they are generally phantom orders," he says. "And that has
to be recognized by the rest of the world."
Why? Because the vast majority of trades put forth by high-frequency
traders are canceled immediately after they are placed. One expert
estimates that 95 percent of all orders are canceled the instant after
they are made.
"It's not trading; it's quoting," says A.T. Kearney's Jenkins. "It is
market actions that are not about trading one security for a quantity
of money. It's quoting and cancelations. It puts noise and volume into
the market that do have some ability to distort what is going on."
At Advanced Trading's Buy-Side Trading Summit this year in Amelia
Island, Fla., one panelist painted a vivid image of today's high-speed
algo trader: "If a human trader behaved the way an algorithm does --
placing hundreds of orders and instantly canceling them -- there would
be fistfights on the trading floor," Brooke Allen, head of the
quantitative trading desk at Maple Securities, said. While the thought
of an annoying trader with two black eyes and some missing teeth
amused the audience, no one seems to disagree with the metaphor.
Possible Speed Bumps
There have been several proposals for modulating the speed of today's
traders. While the SEC's Schapiro appeared in February to step back
from the CAT proposal because of its steep price, industry observers
have pointed to the system used by the Financial Industry Regulatory
Authority (FINRA)as an alternative.
HFT critics also have proposed other measures for slowing down
high-speed traders, including implementing a "high-frequency tax" on
all canceled orders. Some have suggested that high-speed traders
should have to hold onto a security for an entire second before being
allowed to sell it, and other critics have proposed confining HFT to
certain times of the trading day.
A tax on canceled orders, however, could cause collateral damage,
cautions Scott DePetris, COO of financial technology provider
Portware, citing familiar arguments. "Trades are canceled millions of
times a day for any number of reasons," he says. "Charging for
canceled orders will potentially increase trading costs for all firms
and retail investors, regardless of their investment strategy, and
could have a serious impact on overall liquidity."
"Having been in SEC enforcement, I know that information gathered is
confidential and not made public," he continues. "There's a potential
of criminal penalties attached to the disclosure of that type of
information, but what are you supposed to do with an analyst who
learns about how something works? Do you wall him off from doing
anything with quantitative programming?" Noting that this would
severely limit an SEC agent's "marketability" once he or she left the
regulator, Fickes suggests this would exacerbate the SEC's
difficulties recruiting top talent.
And the ripples of HFT taxes and other filters could cause a tsunami
around the global markets, according to A.T. Kearney's Jenkins. "One
country or governmental body promulgates rules, and traders will most
likely trade elsewhere," says Jenkins, who points to new rules in
France as an example. "There's some reasonably significant regulations
being debated within their market, and already some Parisian traders
are looking at the Cayman Islands to set up infrastructure there to
get around these laws."
Life In the Slow Lane?
One question that has not been answered is whether the idea of slowing
down the market is even realistic. Once traders have executed orders
at microsecond speeds, can they return to more moderate millisecond
(or even whole-second) speeds? Anything's possible, says Jamie Selway,
managing director of agency brokerage ITG. "You can certainly slow
down the entire marketplace and it will have the effect of slowing
down the high-frequency firms. It is possible to throw some sand in
the gears," he notes.
But Selway quickly expresses concerns. "There are some [good] things
you can do at the margin -- it's not binary where all HFT is bad or
all HFT is good," he says. Rather than broadly slow down all
high-speed trading, "Regulators should take surgical kinds of actions
on some trading behaviors."
Even the most jaded industry veteran acknowledges that the days of Mad
Max-like trading speeds might be numbered so that some semblance of
order can be brought to the markets. "Yes, there will be regulation --
it's inevitable," says Momentum's Nenner.
Initially, the restraints may be applied through the Self-Regulatory
Organizations (SROs) and through the broker-dealers, Nenner adds. "We
can't beat the speed of light," he says, "so there are certain
constrictions that can be applied now to control the amount of order
flow."
