This version of this article first appeared in FX-MM Magazine, May 8th issue.
By all appearances the financial industry is in for a regulatory tsunami. We’re a flood with news that the Securities and Exchange Commission (SEC) is taking aim directly at algorithmic trading, proposing fees on order cancellations or a minimum resting period for quotes in the book. Such actions are born out of fears that the markets are speeding dangerously out of control. Like a vice grip on reality, they want to exert pressure on market mechanics.
With such prospects on the horizon, get used to headlines such as – “Trading Volume Still Stinks…” and “Toronto Stock Exchange Volume to stay low” taking over your daily news. Trading volume through the end of February on the TMX was down about 16% from the previous year. According to Credit Suisse analysis, volumes will likely continue to trend downward. A direct result of high frequency traders losing interest and “… a change in their activity would certainly impact the overall market numbers” from Ana Avramovic at Credit Suisse.
Chairman Mary L. Schapiro’s recent comments, “we don’t have enough data yet to really be able to justify significant additional steps at this point,” are the portent of an intellectual bankruptcy. Even while high frequency trading (HFT) critics are pressuring regulators, by their own admission they do not have the empirical evidence to justify such rulings. Worse yet, is there any assurance that such actions will reduce market volatility or that we won’t see markets behaving badly? Regulators lack reliable determinants that indicate slowing down high-speed trading will reduce the chance of another flash crash.
The SEC’s Consolidate Audit Trail (CAT) may provide the needed granularity for surveilling and identifying market integrity issues. While the scale and magnitude of the CAT project is obvious, it is also the technological undertaking the SEC needs to do to understand market mechanics and justify regulatory actions. There is always that first step. So what is really behind the recent SEC and CFTC regulatory saber rattling? Is it fears of market stability or that the HFT model so upsets traditional practices long enjoyed by market maker specialists and long-only institutional investors?
The innovation of low-latency, high speed trading was not systemic when it first launched. Successful innovation has a way of rapidly accelerating to maximize the disorder of traditional systems. Just as in the physical world, these are entropic forces seeking to evolve towards a new state. The worry for regulators is that HFT has achieved a scale where their influence in the market is undeniable so it rankles traditional participants who want their old business model and controls back. Much like social media has made traditional news obsolete, algorithmic trading has displaced the old order of things. Pressuring regulators to rid the market of high frequency trading is akin to politicians building a bridge to nowhere or trying to shut down Facebook.
Reportedly HFT contributes 50 to 70 percent of the volume in the U.S. equities market. While this has been a boon to overall liquidity, it is widely spread as algorithmic engines look to make markets across numerous exchanges and dark pools. But with HFTs making on average between $.0005 and $.00075 per share on each trade according to Rosenblatt Securities, an order-to-quote cancelation fee won’t just deter firms from cancelling orders – they will stop trading to limit their risk and exposure. “The ability to quickly cancel and replace orders in response to new information is an essential tool for electronic market makers to manage their open order risk”, James Overdahl, an adviser to the Futures Industry Association’s Principal Traders Group recently wrote in Bloomberg news.
The consequence will be a drop in volume in the overall equity markets similar to what the TMX has experienced. The thinner volumes will only make an already arduous search for fair priced liquidity even harder for institutional traders. When volume is low, no one can be sure whether the bid/offer prices represent the real market value. Lower numbers of transactions massively affect volatility, since one large transaction can have a disproportionate effect impacting all participants.
As with anything creative, change is inevitable. With a sense of regulatory inevitability in the air, the industry is subtly responding by enacting measures to self-regulate. Exchanges worldwide including Nasdaq OMX and Deutsche Bourse are looking to police their own through tariffs and rebates on the order-to-trade ratio. The Intercontinental Exchange (ICE) instituted an anti-quote stuffing policy a year ago that incurs a higher surcharge the further away an order is from market price. Even the foreign exchange markets through a consortium of venues and prime brokers instituted trade-halting measures to build an OTC market that protects itself.
These actions won’t slow the speed of the market but may curb regulators hast. High speed, low-latency trading is an inevitability that will continue to gain ground. The practice is here to stay, the tools of the trade cannot be un-invented. Quantitative trading in equities and across asset classes exploit perceived market inefficiencies created by human behavior, geo-political events and market structure enabling speed to manifest the value. Policing and regulations will only channel a trading firm’s energy, efforts and ingenuity in a direction to compliance to look for ways to manage the controls and still stay in business.
We are at a regulatory inflection point facing choking rules under the guise of improved market stability. As Richard Johnson from at Société Générale recently said, “Regulation is a powerful tool and should be handled carefully”. It’s an epic rivalry between the old and the new, the old traditional market makers and institutional traders and the new high frequency quants. When sacred traditions are disrupted the industry sees threats and challenges, many of which will require each side, industry participants and regulators, to accept a “grand bargain.” In this case, it is clear it needs to be one that allows, at least to some degree, a compromise of self-regulation.
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