Isolationism had once been a pervasive part of American political and cultural life in the 19th and 20th centuries. American independence from foreign affairs, fueled by the geographic separation of two great oceans was the common sentiment for generations. Many felt the turmoil in Europe was of no concern to America. In the era of the Great Depression the general attitude of the country was that it should focus on it’s own domestic problems. Two world wars changed much of that, it was the beginning of a realization that the world is a much smaller interdependent place than in the days of old. Fast forward to present day, Thomas Friedman succinctly outlined the technological and geopolitical interdependence of nations in his book, The World is Flat, a Brief History of the Twenty-First Century.
I believe this general idea is what Bart Chilton was trying to say recently when he spoke of the need for international regulatory harmony at a conference in London. In the U.S. the SEC and CFTC are wrestling with an agenda set forth by the Dodd-Frank initiative. In Europe the ESMA which began operations back in January is seeking to understand and establish its own role as a regulator of the European markets. Regulatory reforms that do not take into account the geopolitical interdependence and interconnectedness of our markets is folly.
The European Regulator, ESMA recently began conducting a study of firm’s automated trading strategies. Since HFT has been under suspicion and intense scrutiny since the Flash Crash, this is a rational approach to quantify numerous aspects of those strategies to determine their potential market impact. Are your strategies typically price takers or liquidity provisioning? Are they multi-asset? I’m sure there are plenty of probing questions. Ultimately they’ll want to… need to determine answers to justify the effort required to address that concern Bart poses on international harmony. To what extent are firms strategies holding leveraged positions cross-border? Having a quantifiable understanding of what firms are doing with their strategies would help shape a plan for cooperation with multi-national regulators.
I recently read an article comparing the high-speed trading world of HFT to Formula 1 racing entitled, Start Your Engines and how racing’s governing body “Federation Internationale de l’Automobile” promotes safety and fairness. The simplicity of the analogy is plainly obvious, but in reality our markets operate much more like an ecosystem where HFT is just one participant interacting among many, not just other HFT firm’s but other traders and investors including pension funds, mutual funds, market neutral firms among others across numerous trading venues from Equities, Futures, Options to Forex across North American, European, Asian and other markets. The interactions and interdependence of such a system is overwhelmingly complex and no singular analogy can
possibly do justice.
Mary Schapiro; chairman of the SEC also realizes the dynamic nature of the markets as an ecosystem when she recently made this statement at a SIFMA Seminar: “… we recognize that applying new rules to an existing market could be disruptive. And so, we are determined to thoughtfully consider how to sequence the implementation of rules …“. Ecosystems are infinitely sensitive to change. Some rules give the appearance of a clear-cut understanding of their impact such as the proposed limit up/limit down rule. Since this particular one is a reactionary measure, designed to quiesce a volatility disruption its overall impact or side-effect is presumably well understood. However, there are other proposals such as Order Cancellation fees which strive to improve market fair-play, but will undoubtedly cause those affected firms to reevaluate those impacted strategies and design other techniques introducing unknown side-effects.
The recent CFTC-SEC Advisory Committee report outlined a number of rule recommendations, many of which were focused on that notion of improving market quality (reducing volatility, improving liquidity). This of course is at the core of the ongoing debate on HFT. Arguably the most important was recommendation 9, determining Market Maker obligations and/or incentives. There has been quite a lot of academic research to determine HFT’s market impact. Does it improve market quality or is it harmful? The studies provide plenty of mathematical proof through data analysis for both camps. But I think part of answering this question is to first get a clear understanding or profile of how firms deploy high-frequency (HF) strategies, which are price takers and more importantly which are making a market (i.e. liquidity provisioning)? Price takers are typically focused on arbitrage and are not too concerned with their trading activity’s impact on market prices; as such it seems plausible their activity could induce short-term liquidity spikes. The circuit breakers and limit up/limit down rules should cover that.
However HF strategies as liquidity provisioning are another matter entirely. As is now well known it was unobligated liquidity, or lack thereof that induced the crash of May 6th. The CFTC-SEC Advisory Committee report recommends the SEC/CFTC employ obligations or incentives to encourage firms to stay in market during stressful time, but falls short of outlining specific actions. I would guess this is what ESMA, the European regulators are also trying to determine, just how to tackle this thorny problem. Gathering the data through their questionnaire is a good start. Another possible consideration is a research project from Cornell University. This venture recently outlined in Advanced Trading, defines a measure known as the VPIN metric (Volume-Synchronized Probability of Informed Trading). It is designed to be a predictive measure of order toxicity. Order toxicity is a term to describe a condition where one counterparty is more informed than the other; often with hard evidence of the direction the market is headed. As a result, it can cause enormous trade imbalances that result in liquidity crises the likes of which induced the flash crash. Firms armed with the VPIN metric would have a more informed picture of flow on a per instrument basis. As such this provides a means to reduce risk and better manage positions. The suggestion outlined in the research is to create a VPIN contract on the futures exchange, loosely analogous to the VIX. VIX is the volatility fear index based on a subset of the S&P100 OEX. Since VPIN is a per-instrument toxicity measure, creating a VIX-like contract that would still have the same statistically significant correlation as outlined in the research seems a bit suspect. Nonetheless, the predictive metric would be publicly available as a hedging mechanism to any/all firms. VPIN is obviously not a regulation or obligation for market makers. But it is an incentive-like choice, firms could use it is as a risk reducing technique because it provides a means to be anticipatory to a liquidity crisis.
For regulators to understand the right approach to bring new regulations and change to our markets to improve market quality and create fairness and equity for all participants starts with the realization that we cannot think like the isolationists of past eras. Just like technology has re-shaped the geo-political landscape and flattened the world, our markets know no borders. The flash crash highlighted not only their interconnectedness but their interdependence. This is the definition of an ecosystem. Regulators must recognize that, new regulations will potentially have that Butterfly effect, there is no denying it, stepping lightly is a wise choice.
Once again thanks for reading.
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