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Home > Blogs > Ian Fraser > Exchanges have much to lose as high frequency traders get emasculated

Exchanges have much to lose as high frequency traders get emasculated

High frequency traders affect exchanges Ian Fraser

There can be little doubt that high-frequency trading (HFT) is a malign force in the financial markets.

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'."

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.

Additional note:


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.

Further reading on high frequency trading and exchange traded funds:




Tags: algorithms , algos , Andrew Bowley , Andy Haldane , banking , Bernard S. Donefer , Borsa Italiana , CFTC , Charlie Munger , City University of New York , Commodities Futures Trading Commission , Deutsche Borse , Fidelity Investments , Flash Crash , front running , Goldman Sachs , HFT , high-frequency trading , INET , Joe Saluzzi , legalized front running , liquidity , London Stock Exchange , Milstream Strategy Group , Nasdaq OMX , Nomura International , NYSE , Pipeline Trading Systems LLC , regulation , Scott Patterson , SEC , Securities and Exchange Commission , self regulation , stock exchanges , Themis Trading , US , Wall Street Journal
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  1. zeitgeist says:
    Sat Apr 21 03:53:03 BST 2012

    It is not possible to "instantly trade ahead of" "orders as they emerge", and HFT has nothing to do with front-running. By definition, an order has to already be on the exchange if it shows up in the data feeds that HFT firms can see. Flash orders do not exist anymore, and you should know this already. There is nothing inherently wrong with using complex algorithms. Anyway, the algorithms used by high-frequency traders are far less complicated than the process humans go through to evaluate a value investment or look for new arbitrage opportunities at a fundamental mutual fund or hedge fund. HFT is socially beneficial. It narrows bid-ask spreads, making it cheaper for longer-term investors to trade. It eliminated the old system of corrupt "exchange specialists" and their cronies, dramatically reducing the amount of money that flowed to middle-men in the system. It makes trading cheaper for pension funds and mom-and-pop investors. HFT does not amplify market movements. It is by nature a mean-reversion bet, since momentum decreases the profitability of market-making. HFT cannot inflate asset price bubbles. That's done by directional speculation. You need a net capital inflow to inflate a bubble, and market makers by definition want to end the day flat. All HFT does is make it easier for other investors to trade with each other. An error by the NYSE was the actual cause of the Flash Crash, not the W&R futures sale or the subsequent adjustments by HFT firms. HFT just allowed the market to recover faster (unlike in 1987 when it took months, instead of the 20 minutes or so that it took for the Flash Crash to pass). The NYSE implemented an order submission queue incorrectly, causing it to broadcast incorrect information that led to the market crash. See detailed analysis and evidence from Nanex datasets here (http://www.nanex.net/20100506/FlashCrashAnalysis_CompleteText.html). HFT firms compete strictly with *each other*, not with longer-term investors. They don't care what the next earnings release is going to be, or what condition the economy will be in in five years. They are solely focused on how to quote a tight spread without losing money in the next 500 milliseconds. If you want to bet on Apple's earnings, HFT is not going to make it any harder for you to do so. They're not even looking at the fundamental data for the most part, much less making bets on specific company performance metrics. Charlie Munger is a very good fundamental investor, but he is not an expert on HFT. Quoting Munger on HFT is like asking Einstein about cancer research. Yes, HFT firms cancel a lot of orders. They have to do so in order to keep the spreads tight. If they didn't, they would have to quote wider spreads, which would make it more expensive for long-term investors to trade. Order volume does not impose an externality on long-term traders. Long-term traders generally subscribe to lower-frequency datasets that do not contain the full market book. Indeed, this type of data feed is cheaper. Haldane's claim about externalities is therefore unreasonable. Frankly, if you're looking at the entire order book, you are probably a human trader trying to make markets. Go do fundamental analysis instead. Market-making is inherently better done by computers. This is like trying to design a new car using a wind tunnel instead of a computer simulation, or trying to manufacture a new product by hand instead of using automated factories. The world has moved on. The authors of the SEC report on the Flash Crash were not aware of the NYSE queue issue. Their results are incorrect. Selling between different HFT firms cannot cause directional price movement, because no particular firm is accumulating a net position. Volumes might increase under such circumstances, but without a directional influence, the market will be flat. The directional influence was provided by the NYSE's queuing error. Therefore, the NYSE is at fault, not the HFT firms. Dark pools are not used "to fleece the uninitiated". They are used by sophisticated institutional investors (e.g. hedge funds, mutual funds) to buy and sell large blocks of stock. They are a professional tool. Retail investors don't even have access to them. Joe Saluzi's "powerful riposte" is nothing more than a series of bullet points that he fails to elaborate on. His business model competes with HFT, so he's biased anyway.

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