Business Spectator: sleepy regulators must sever the pipes

Business Spectator: sleepy regulators must sever the pipes

Sep 29, 2012. | By: Fil

Business Spectator ran an article outlining the latest fear instalment on HFT in Australia.

These traders have been allowed to have a pipe into the major markets to give them an advantage over legitimate stock buyers and sellers. Business Spectator has led the world in highlighting the insider advantages these traders have secured (Getting the jump on high-frequency trading, July 18).

The referenced article makes some fundamentally misleading statements on HFT in Australia. It talks about an "insider trading network" operating in Australia by HFT. What nonsense.

Insider trading is trading for your own benefit based on non-public information. Whilst this has arguably been true in the US, with flash orders and a complex market structure, it has never been so in Australia. To imply that it has been in Australia is either running shot-gun over the facts, or deliberate scaremongering.

Put simply, there are no avenues for obtaining non-public information from the ASX by HFT firms. While some will argue that the price feeds they obtain (technically known as "ITCH") are faster than other feeds, you should remember that these technologies are available on a equal access basis at very reasonable cost. The advantage that HFT firms have, is in their technology to process the data - not obtain it before everyone else. The fact that HFT firms colocate is not, in fact, to beat non-HFT traders to the punch (they do this without raising a sweat); it's to beat other HFT firms.

HFT firms just do things quicker than retail traders, but this does not make them 'insider traders'. It just is a fact that the market rules (price-time priority) reward this kind of behaviour. Maybe we should direct our attention there, rather than conjuring up visions of queue-jumping cheaters? TimeMatch is a proposed solution that addresses the market rules, rather than just making illegal the most successful traders under the current ones.

The New York Times reports last night that global regulators are trying to stamp out the practice with new regulations. And of course because the large genuine institutions do not like being ripped off by the high frequency traders, and their pipes into the market, legitimate people have left the large exchanges. They have started what are called dark pools, where effectively legitimate institutions trade among themselves. It’s not ideal but better than the stock exchange system.

'Genuine institutions' (non-HFT) is right to be concerned about the impact of HFT in the US, and to a lesser extent, Australia.

Contrary to popular opinion, there is not an exodus to dark pools in Australia. The share of the lit market recent years has actually increased (marginally). What we've seen is a shift from broker crossings to dark pools. This actually is quite a positive indicator for the health of the ASX, but one that seems to be missed on the doomsayers. Unfortunately news telling you the sky is not falling in, does not attract as many readers. Any 'exodus' to dark pools has been from the broker crossings only.

One part of this story that gets neglected is that in the lit market there has been a shift (exodus may be too strong a word) from the continuous market to the opening and closing auctions. In my mind this reflects a very rational response to the continuous market. During the auctions there is less HFT gaming going on (not zero, but less) and you are less exposed to latency arbitrage since HFT's do not control the timing of execution - the exchange does.

Saying dark pools are not ideal is an understatement. They have negligable regulatory oversight, and don't have anywhere near the obligations that markets operators have to be fair to all participants. As I've previously said, the fact that someone is willing to use them indicates there is something wrong with the lit market. My hypothesis is that liquidity creators do not have enough control of their orders on the ASX, leading some to opt for other off-market possibilities such as broker crossings or dark pools. Broker crossings have no exposure to HFT, since the one broker has both sides of the trade, and dark pools often have buy-side friendly HFT countermeasures in them to prevent predatory behaviour.

The CEO of the ASX Elmer Funke Kupper in in his KGB Interview agreed that if the regulators failed in these current efforts, then cutting the pipes were the only solution.

He hardly agreed - this suggestion was proposed and EFK rejected it:

EFK: And so, what we need to do is rather than cut the pipes, which I think is not going to happen...

RG: Should.

EFK: ...is make sure that – I understand your opinion, but I don’t think that that’s where we’ll go – is to make sure that the economic incentives of the behaviour are more aligned with the market place...

The above reading that EFK was proposing the 'pipes be cut' looks pretty deceptive..

My view is that the high frequency traders are making so much money and the regulators are so sleepy that the new regulations will fail.

Well, sleepy is pretty emotive: but yes keeping up with the impact technological innovation is difficult for a regulator. There is a lot of money in HFT so no doubt they attract a lot of talent to keep one step ahead.

I agree with the overall sentiment in that the regulators will find it tough: I actually think regulation is not necessary. The regulators have a lot of influence (with the threat of regulation) that I think can steer things in the right direction, but I think legislation is the last resort. A scheme like TimeMatch is a good market-based response to HFT to help, and a number of other innovations at the exchange level could level the playing field for all.

The idea of regulating HFT out of existence disturbs me: how do you decide what is HFT? It is kind of like trying to get rid of criminal bikie gangs: do you define them by the fact they ride bikes, the number of tattoos they have, or the kind of beard? Perhaps you could invent some ratios, and research the correlation between these ratios and criminal activity. What you end up doing is making certain combinations of bikes, tattoos and beards illegal - not the activity itself. There's bound to be some collateral damage there :)

The same thing happens with regulators trying to expunge predatory HFT: except you look at things like quote-to-trade ratios as the target (as Germany has done). It's a strategy of last resort - something you do to look busy, not something you actually expect to work.

Allowing the market to regulate itself (by exchanges providing greater control to liquidity providers) is a far more flexible solution, as it allows the market to adapt to new threats. As HFT change their strategy, the market can counterbalance the pressure far better than regulators can.

I hope I am wrong. There is only one way around the problem created by the pipes that the legalised insider traders have into the market – the pipes must be severed and the markets restored to fair places to do business.

How exactly would you 'sever the pipes'? Presumably the ASX would be prevented from providing trading services to HFT firms - so how would you define those HFT firms? Invent a whole lot of ratios, and pretend that the regulator knows best in picking the good guys (who get to remain in business) from the bad guys (who are out of luck). This is the root of the problem - you don't understand what is going on. You see symptoms, and you want to attack them directly. This is futile, as the root cause of the issue goes unresolved.

Removing all high speed (in human terms) trading firms would be a net loss for the health of the market. What we need is a way to help the good HFT, and curb (read: put of out business) the bad ones.

But in the US regulators are so bad that they seem corrupt. Next week the US Securities and Exchange Commission is hosting a round table on the topic but the agency has not proposed any major new rules this year. The conference is simply window dressing.

Agree. The regulation in the US has added to the advantage that fast HFT holds over the wider market.

In contrast, the German government this week advanced legislation that would, among other things, force high speed trading firms to register with the government and limit their ability to rapidly place and cancel orders – one of the central strategies used by the firms to take advantage of small changes in the price of stocks.

This reform would make a world of difference in the US, but none in Australia. There is no one-size-fits-all rule here. The answer lies in: control. At the moment the market is controlled (in the short-term) by those who are the fastest, since that is what the current market rules dictate (price-time priority). Change those rules (TimeMatch) and the control shifts: to the liquidity providers - of both HFT and non-HFT flavour.

The New York Times reports that in Australia, the top securities regulator recently stated its intention of bringing computer-driven trading firms under stricter supervision and forcing them to conduct stress testing, to protect “against the type of disruption we have seen recently in other markets.”

ASIC's proposals I think are fairly unimaginative and unless they can operate at the microsecond level (read: impossible) wont prevent the next market break. ASIC need to stop asking everyone to "do a better job" (stress test this, please put in kill switches etc.) and influence some real reform at the exchange level. At the end of the day you can trust the operation of the exchanges, you cant trust the firms behind it.

From another perspective it always seems that regulators are perpetually preparing themselves for the previous catastrophe, not looking forward to the next evolving one.

However the broadest and fastest changes have come out of Canada, where this spring regulators began increasing the fees charged to firms that flood the market with orders. The research and trading firm ITG found that the change had already made trading more efficient by reducing the crush of data burdening the market’s computer systems.

ASIC have already acted in this direction with the 'message tax' - and has reduced the quote-to-trade ratio on it's own. Not that the burden of data was high in global terms prior in any case.

It's good to see that the regulators acting but I just don’t think they are smart enough.

Their job is to create an environment where the smartest people can act for themselves, not create an environment where they potentially can't.

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