By Richard Bentley, Vice President, Capital Markets, Progress Software
In 1963, Avis owned up to being only the second largest car rental company in the U.S. (after Hertz). "We try harder because we have to" was the catch phrase. The advertising campaign was a massive success; it gave Avis more business and a new brand identity.
Sometimes being second is the best place to be. In the case of high frequency trading, the emerging markets coming to HFT behind more 'developed' markets are benefitting from being second. Brazil, in particular, has benefited from this 'second mover' advantage, by paying close attention to the lessons learned in the U.S. and Europe.
Being first to HFT had some distinct disadvantages. The U.S. jumped into HFT with both feet after Regulation National Market System (Reg NMS) came into effect in 2007. In Europe, after the Markets in Financial Instruments Directive (MiFID) opened up its markets in a similar vein, HFT participants moved in quickly. Both markets grew at a rapid-fire pace with new trading destinations popping up; the resultant fragmentation presented opportunities for HFT and algorithmic trading that few regulators were prepared for.
The May 2010 Flash Crash brought a screeching halt to HFT's proliferation in the U.S. as the SEC determined to get a grip on the potential dangers of HFT. Naked access, stub quotes, flash orders and other practices deemed unsafe were banned. In Europe, alarm over the U.S's experience created a rush to control high order-to-trade ratios and the EU is mulling more draconian regulation to come.
Brazil looks less like a cowboy's paradise for HFT (like the U.S. and Europe) and more like the nation where the Sheriffs (regulators) are in charge. BM&F Bovespa - the national Equities and Derivatives exchange - has never allowed naked access, nor does it have a maker-taker fee model to encourage volume through rebates. There are no flash orders, and no NBBO , which was a consequence of fragmentation in the U.S. Brazil has always insisted on pre-trade credit controls and never allowed dark pools.
When HFT was in its infancy in Brazil the government instituted a tax to discourage too much foreign market participation. Although designed to rein in currency speculation and domestic inflation, a side effect was that it also slowed the growth of HFT while procedures were being be put into place, and gave regulators a chance to watch and see its development. In December 2011 Brazil lifted the financial transaction tax for foreign investors.
Bovespa has also been investing heavily in its trading platform to improve speed and processing capabilities. And it has tweaked its direct market access rules and there are now four categories of DMA, enabling complete flexibility along with safety nets. Its policies have worked and it has become the go-to destination for HFT with volumes climbing steadily. (In the U.S., on the other hand, volumes have been dropping of late as exchanges get ready to adopt policies to penalise traders for excess quotes)
High frequency trading is a relatively new phenomenon and as such has a lot of growing up to do. Its evolution will take place naturally, as we have seen in Brazil. The lesson here is that, while regulators should be alert to the issues created by new trading methodologies, they should also realise that HFT is not synonymous with market abuse. There are certain forms of market manipulation - like quote stuffing - that HFT makes possible and these rightly need to be outlawed and policed. However, HFT per se is not abuse. In the old days before electronic trading no one tried to ban the guys who could shout loudest or run across the pit faster than others.
The debate around HFT in the U.S. and Europe has become politicised and HFT has been grabbed onto as a scapegoat, but HFT didn't bring down Lehman Brothers or cause the EU sovereign debt crisis. Many of the issues with HFT will sort themselves out without overt intervention. Markets have a habit of evolving naturally by weeding out the bad and unworkable elements. Brazil, as second mover, shows this.
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