When a definition is elusive, more subjective in nature than objective should that not dictate more discretion and a rational approach to achieve a goal? When the CFTC’s Scott O’Malia set out to define high frequency trading through a seven-part test, definition was not his objective but simply a means to an end. That end was a lever to enable further regulatory action in the coming New Year.
Speaking of regulation, SIFMA recently published a year-end study, The Impact of HFT where they mention the difficulty in creating a clear-cut definition. HFT does not neatly fit into any one well-defined bucket, but like so much of trading belongs to an overall categorization. A style trading that… a) leverages computer technology, b) makes use of algorithmic market making, arbitrage and directional strategies, c) limits human intervention. Numerous buy-side, sell-side and quant firms fit into this categorization.
SIFMA’s Impact study does a nice job of summarizing the year’s regulatory actions. All those actions were designed to reduce uncertainty and the resulting risk premium in the market. A rippling backlash we’re still feeling 18 months later from the flash crash. Here are my ‘most important’ from last year and for the next year.
Most important regulatory action of the year:
The Market Access Rule. A euphemism for the Naked Access ban, this rule broke the unfairness certain participants were able to achieve in bypassing Broker pre-trade risk validation. Those extra few milliseconds (or even microseconds) meant an edge for quoting or capturing a trade. Besides the fairness implied by the ban, instituting this rule has had a number of positive side-effects; a) it minimizes the possibility of a rogue algo wreaking havoc. Here’s a prediction for the New Year. There will be no billion dollar rogue algo, and any such rhetoric is journalistic sensationalism solely for the back pages of the New York Post. The Market Access Rule for Brokers, Exchange monitored risk checks and the multitude of watchful counterparties will prevent anything but minor Infinium Capital style skirmishes from occurring. The embarrassing public hand slap they received will ensure firms will beef up their own testing before deployment. Any additional proposed regulations for algos (i.e. controls and/or source code inspection) are unnecessary. b) Increased adoption of hardware acceleration in trading infrastructure. On one hand, the Market Access Rule has leveled the playing field so-to-speak. The requirement that all orders run through the same (regulatory-defined) series of risk checks eliminates the advantage of Naked Access. That was a benefit to both trading firms that could afford the privilege and for Brokers marketing an attractive option in an effort to garner additional client order flow. Poof, that disappeared overnight. Well aware of the consequences, Brokers have rushed to hardware acceleration for pre-trade risk checks engendering a new (regulation-ascribed) low-latency battleground. Witness the announcements from Morgan Stanley, Bank of America and Deutsche Bank earlier in the year. We’re not done yet, more to come in 2012.
Biggest regulatory concerns moving into next year:
1) Increased transitory volatility. There is no denying the turbulent markets are whipping up a frenzy of finger pointing. Who or what is at fault? The tumult of the market volatility has been blamed on numerous scapegoats including HFT and the human emotional response to bad news from European sovereign debt to Washington political divisiveness. One of the side effects of present day communication technology is our ability to react to news from around the global moments after events happen. Smart phones, social media and news-based algo strategies have only extended and exacerbated this phenomena. Volatility is not likely to ebb in the coming year; whipsawing markets are to be the new norm. Managing them is the solution so they do not run out of control. The SEC proposed Limit Up/Limit down price collars will offer protection against extreme volatility through a 5 minute pause in trading contingent upon the market’s reaction to the up/down rule’s ability to stabilize contra-side liquidity. This is a more complex definition of the existing single-stock circuit breakers, but likely an improvement that will mitigate larger volatility swings and will have a wider calming effect.
2) Defining Market Maker obligations. I suspect there are few things that create fear and loathing for regulators as much as the difficulty in solving obligations for liquidity provisioning. Regulators have to eventually face this difficult issue. Avoidance which has been the order of the day for the past year is not a permanent choice. HF Traders and other liquidity provisioning firms have no market obligation other than to their own bottom line. A liquidity drought is the fuel that can ignite another flash crash. Incentive mechanisms similar to the exchange rebates or amicable regulations to keep these participants in market during stressed market conditions are long in coming. However, this is not an easy problem to solve with a good chance of backfiring. Firms could simply move to more regulation friendly markets in other parts of the globe. Resulting in thinner liquidity and creating the very drought-like conditions regulators want to avoid.
The FIA Principal Traders Group (PTG) recently posted a response to Mr. O’Malia’s HFT definition. They took issue with nebulous terms; such as “high” and “numerous” as in the statement: “The submission of numerous orders …”. Similar to SIFMA’s argument, trying to objectively define a subjective category is arbitrary. Doing so will simply result in numerous exceptions to the rule once you apply test cases to determine the validity of the definition. The PTG present a rational argument to take advantage of existing regulatory controls, put in practice proposed rules and leverage audit trail surveillance systems.
Both SIFMA and the PTG appeal to reason with an argument devoid of emotional rhetoric, presenting a rational approach to the task of conquering market uncertainty.
Once again thanks for reading.
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