I AM inundated with requests to help unravel the mysteries surrounding High Frequency Trading (HFT).
The CFTC (Commodities Future Trading Commission) calls its traders (HFTs) “cheetahs” – they are first to the kill in the markets: “If markets are going to be efficient and effective and less volatile, we need to cage the cheetahs.”
Most readers are not familiar with their dealings – who are they? How different are they in making deals? Are what they do legal? Do they play fair? And many more. Recent interest in them was generated by Michael Lewis’ new book: FlashBoys – Cracking the Money Code which I read recently while in Melbourne. Michael is doubtless a compelling story teller. His new non-fiction thriller unfolds the complex, fascinating world of this largely invisible market icon. Indeed, he alleges that the enabling policies of Wall Street exchanges and regulators did little to discourage what HFTs do best.
More bluntly, Michael (of Liar’s Poker and The Big Short fame) claimed on TV’s 60 Minutes in early April that the US’s US$22 trillion stock market is rigged by HFTs. It’s not surprising that some Wall Street titans, including Charles Schwab (founder of the old established discount brokerage house) agreed, describing the practice of HFT as “a cancer undermining confidence in the free enterprise system.” To be fair, other high profiles on Wall Street also insist that few investors are actually hurt by the activities of HFTs; in fact, these “New Barbarians” do have redeeming features, including injecting competition, generating market liquidity and lowering transaction costs.
As I see it, in a market-based competitive environment, any violation of the spirit of the rules undermines the larger game, regardless of how few investors are directly or indirectly hurt by HFTs. Imagine a similar defence by an Olympic gold medallist’s illegal use of performance enhancing drugs, which after all do not hurt a large number of other athletes. Bringing intensive competition does not automatically bring about ethnical performance. As far as I am concerned, the absence of strong principles and sound enforcement often lead to criminal-like behaviour and lame rationalisation. It is a pity that financial markets sometimes reward malfeasance rather than merit.
However, it’s good to know regulators have since showed renewed interest in them. Both US and New York Attorney-Generals and the Securities and Exchange Commission (SEC) have started to target their investigations at the relationship between stock exchanges and HFTs to determine whether it violates insider trading and market manipulation laws (Insider Trading 2.0), or brings about a level playing field.
Use of certain terms defines the manner current literature is written:
Algorithmic trading – or automated trading; the use of electronic platforms to execute trading orders in a pre-determined, robot-like manner, often without human intervention. HFT represents a special class of such trading.
High frequency trading – uses highly sophisticated technological tools (including drones) and computer algorithms to very rapidly trade securities. They exploit an arsenal of lightning-speed computing, using high-powered servers, ultra-fast fibre-optic cables, and a vast trove of microwave transmission towers to reduce trade execution time to microseconds ahead of everyone else to capture tiny price changes. HFTs can close a deal in 13,000ths of a second – a blink of the eye! HFT takes different forms: (i) paying exchanges for faster access to data on order-flows to give HFTs a head-start; and (ii) using algorithms to analyse unfilled orders to enable HFTs to trade stocks ahead to take advantage of pending price changes. Profits from HFT will be US$1.25bil in 2014, down 35% from 2013 and 74% lower than the peak of US$5bil in 2009. HFT accounts for 51% of total stock trading on Wall Street, against 61% in 2011.
Flash crash – a very rapid and deep fall in stock prices occurring within a very short time and recovering just as quickly. It last occurred on May 6, 2010 when a US$4.1bil trade on Wall Street resulted in the Dow Jones index falling over 1,000 points and then quickly bouncing back – all over in 15 minutes.
Front running – closing a deal on own account, taking gains from unfair advantage of advance inside knowledge of pending orders from clients and of access to an ultra-fast network revealing specific trades other people are trying to make. Akin to insider trading. It’s illegal except when HFTs do it.
Dark pools – private forums or exchanges for trading securities that’s not open to the public; usually used for large off-market block trades, so that investors don’t have to show their hand until the deal is done.
Lit-pools – unlike dark pools; here, bids and offers are transparent to all.
Insider trading – a misuse of confidential information for one’s own benefit, which constitutes a breach of fiduciary duty. It’s illegal.
Layering or spoofing – a form of market manipulation; orders are made for the appearance of activity to induce others to deal, only to be cancelled later.
Pinging the markets – multiple orders are sent out to determine whether any will be filled, to gauge the share’s direction; 90% are then cancelled.
Wall Street is rigged
Lewis contends certain firms have built technical advantage in terms of a few microseconds to trade ahead of others to reap unfair profits. Investors realise that whenever they order to buy or sell, the price just moves against them as though someone is one-step ahead. That’s HFTs at work – their edge emanate from two sources, exploiting: (i) time differences (investor wanting to deal signals the broker who searches exchanges for the best price; but order arrives at different exchanges at separate times – HFTs steps in to arbitrage; they race ahead, buy the stock and sell it back for a bit more than the investor had hoped to pay – all in a matter of microseconds, millions of times a day to millions of investors; and (ii) the usage of dark pools (HFTs are allowed access for a fee to the flow of orders in order to prey on investors).
So Lewis claims HFTs rig the stock market. Their algorithm-driven real-time trading works like the old Wall Street scam of front running, except it’s entirely legal – an unintended consequence of well-intentioned SEC Regulation NMS’05 which discontinued the longstanding practice of going for the “best execution” of a trade, in favour of the “best price” for the client. Technological advances meant the best price in the exchanges is as determined digitally over milli-seconds. In 2005, 85% of US stock market trading was done on New York Stock Exchange; the rest on Nasdaq. By 2008, there were 13 different exchanges, mostly stacks of computer servers in Chicago and New Jersey. Critics say HFTs make markets less stable and more volatile because of their speed and high volume. Its technology architecture has brought about a flash crash and other market hiccups.
HFT an unfair game
HFT’s problem is that its business model doesn’t fit comfortably into classical theories of securities fraud used to pursue misconduct. Five types of abuses:
Insider trading (ITG) – HFT appears to fall outside the ban on ITG as currently defined because firms pay exchanges for access to order-flow information; no laws are violated since data is legitimately purchased.
Front running – Lewis likens HFT to “computerised scalping”, allowing firms with the fanciest software and speediest machines to front-run i.e. where a broker buys or sells before executing a client’s order. Since HFTs trade on their own account, they have not traded ahead of their clients. It is paradoxical that exchanges profit from selling access to data which are then used for trades akin to front-running, in the face of rules that clearly prohibit brokers from this practice.
Layering or spoofing – such market manipulation (MM) are being cracked
Pinging the markets down – Proving MM, including wire-fraud statutes, means showing either an intent to artificially affect stock prices, or to defraud others: (i) HFTs seek out the best price to trade ahead of others, but not to drive the price up or down; and (ii) proving intent to defraud requires depriving the victim of property; indeed, HFTs make split-second price decisions that has nothing to do with the shares’ underlying value.
Other scams – SEC allows HFT firms to “co-locate” their computers inside the exchanges to secure their speed advantage; and to buy data-feeds and have early peek at business news releases, data they can use to trade before others, all in the name of providing equal market opportunity.
“FlashBoys” concludes that HFTs are given unfair advantage to rig Wall Street. Ironically, the intent was to rig SEC rules to favour individual investors! IEX – an upstart alternative (HFT-proofed) exchange, now offers to “play fair” by staggering trade requests from other exchanges using “speed bumps” to level the playing field, thereby by-passing HFT electronic front running.
What then, are we to do?
HFTs appear to be off-the-hook in not violating current rules on permissible trading. Even so, it does not entitle them to use lightning speed to grab best prices. That’s not right: “The tactic smells to high heaven.” Markets have simply become too complex, thereby creating advantages for the sophisticated like HFTs. Hence, the growing concern for regulatory distortions and conflicts of interest as regulators continued to flounder. To me, information is key. Regulations have to move towards more open and more transparent markets. When they do work, investors are better off. But we can’t turn back the clock. HFT is here to stay. After all, we are all HFTs now. The issue is how to resolve at least the perception of fairness in the markets without denying the benefits brought on by HFTs – improved liquidity through bringing in more buyers and sellers, narrower spreads between bid and ask prices which in turn, lower trading costs for all.
In the end, regulators need to figure out a way to balance these benefits while combating the widespread view that markets are rigged. Markets need confidence to thrive. More needs to be done to calibrate the obligations and privileges of HFTs. Fixing the market through levelling the playing field certainly helps, including creating more lit-pools, making market data freely available on a timely basis to all; there are 40 dark pools and 13 exchanges – either every market is allowed to discriminate or none should; and requiring brokers to protect the integrity of customers’ orders. The goal is to ensure the benefit of speed do not overwhelm the benefits that come with transparency, liquidity and stability. What’s really needed is to simplify the operations of markets to restore confidence and instil fairness for all. European Union’s soon-to-come curb on HFTs hopes to “strike a decent balance” so that HFT “doesn’t cause instability and isn’t a source of market abuse.” We’ll see.
- Former banker, Tan Sri Lin See-Yan is a Harvard educated economist and a British chartered ccientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: firstname.lastname@example.org.
- The views expressed are entirely the writer's own.
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