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The high frequency trading (HFT) debate seems to have entered a new and worrying phase in the UK. On Tuesday this week in an interview with the BBC, Lord Myners, the UK’s financial services minister, warned that high frequency trading had “gone too far” and that share ownership had “now lost its supporting function for the provision of capital to business”. (You can find the original interview here and reports of it in the Financial Times and The Independent yesterday).
Mary Schapiro, head of the SEC, signalled at the end of October that a number of electronic trading areas were going to be looked into – naked access (where a broker sponsors a firm to have direct electronic access to an exchange), dark pools and high frequency trading.
It does seem now that on both sides of the Atlantic, governments and regulators are steeling themselves to act and softening the markets up to be able to accept the fact that electronic trading might have some limits.
The concern is that governments and regulators are going to come down too hard on electronic trading and the benefits that it gives investors will be damaged.
It all started with the flash order issue in the US a few months ago. Commentators were linking together various different, although related issues, in an inappropriate way. Flash orders seemed to be viewed sometimes as being synonymous with HFT, both of which were sometimes reported as forms of market abuse. All three topics are quite different. In my opinion, there are legitimate questions over the use of flash orders and a proposal to ban them is now being considered.
Dark pools, where large blocks of stock are traded off exchange to minimise market impact, have been the next targets. There are, again, legitimate issues. Dark pools, by their very nature, do not have good price transparency. Regulators have become concerned with their use because more and more trading is going through dark pools. Some estimates put this at between 10% and 30% in Europe and the US. This lack of knowledge about what exactly is the proportion is part of the problem itself. No one really knows what proportion of trading dark pools is taking. If a significant proportion of the market has no price transparency then this undermines the notion of a fair market for all. Regulators are looking at this and its likely that they will force dark pool operators to disclose far more information about what is being traded than they do currently. The SEC is considering limiting the proportion of a stock that can be traded through dark pools to a small percentage.
These legitimate issues however risk skewing the whole HFT debate to one where people will conclude that “HFT is bad”.
What people are now describing as HFT – the very fast and frequent, computer assisted trading of, usually, equities – is an evolution of something that has been happening in the market place for at least the last 10 years. In this time electronic trading has proliferated, not just in equities but also in all asset classes such as derivatives, bonds and foreign exchange. Far more venues for trading have been created. There are now many places where a company’s stock can be traded both in the US and Europe. This has brought competition and choice. Prices have been lowered, improving access to retail investors. Spreads have narrowed. Arbitrage opportunities are harder to find, which mean that market information is disseminating faster which, in turn, means that price transparency has improved. Because there is more trading going on, there is more liquidity available, which also means keener prices.
A key part of the HFT trend has been the use of algorithmic trading (the most prevalent use of complex event processing technology). Algo trading models fall broadly into one of two camps: alpha seeking, where market prices are examined to find a trading opportunity that will make money, and execution where orders are, usually, split up into smaller parts and then traded automatically in the market in an intelligent way to find good prices and to ensure those prices are not overly influenced by the trades being made themselves. For each type of model it can be very useful to react very quickly to market information, either to take advantage of a price discrepancy or to quickly pickup liquidity at a good price. Algorithmic trading is enormously beneficial for those who use it and its use is not limited to specialist hedge funds. Most algorithmic trading uses execution models that find liquidity, good prices, help minimise market impact and, lastly, increase significantly a trader’s productivity. Instead of wasting time executing several simple orders in the market over the course of many minutes or hours, the trader can simply ask a machine to do it. The trader can then spend time either covering more of the market (useful in straitened economic times) or spend more time actually delivering real value to a client.
Algorithmic trading and HFT have brought very significant benefits. It is these benefits that must not be threatened.
Trading has always involved cunning and guile, whether human or computer based. Competition has always existed in who’s got the best traders and trading systems. Organisations investing in ultra low-latency infrastructure to ensure orders arrive at an exchange in microseconds (not nanoseconds as sometimes claimed by the way – light travels 30cm in 1 nanosecond which isn’t far enough to be very useful) are part of this competitive world. Competition leads to innovation and it is this innovation that has brought so many of the benefits described above. Computer-based models can somtimes be used abusively. There are many forms of market abuse that regulators and exchange operators look for. Some exchanges and regulators have been investing in real-time surveillance technology (Progress counts Turquoise and the UK Financial Services Authority as customers using Apama) to ensure that they can spot abusive patterns of behaviour quickly.
We can’t start slowing trading down. We can’t go backwards and put the electronic trading genie back in the bottle. We don’t want to lose all the benefits that have come. Rather, regulators and exchanges should concentrate on ensuring maximum transparency in how markets operate and ensure that those attempting to maliciously abuse the markets are dissuaded or caught.
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