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Tuesday, January 22, 2013

Whether good or bad, subsidizing Wall Street's high-frequency traders is costing the market?

On May 6, 2010, the Dow Jones Industrial average plunged nearly 700 points in minutes before recovering. That event was tagged a “flash crash” and was blamed on high-speed trading on the floor of American stock exchanges. High-frequency trading (HFT) for the uninitiated, is the use of electronic trading platforms for entering trading orders using computer software.

Bears symbolize pessimism in the market. Flickr.com/dbarronoss
HFT is noted for its speed in initiating huge numbers of orders, sometimes even without human intervention. HFT also accounts for huge numbers of order cancellations which serves as a cause of concern in the market. Is this practice good or bad, no one can say for certain, but the perceived profits high-frequency traders make is a big burden to the market because the huge costs to other traders who are institutionalized is very high.

HFT – an arms race in speed

HFT firms used to operate in the shadows far from Wall Street. But more recently, they have been more vocal in seeking recognition, buffing their image with the Securities Exchange Commission (SEC), other institutionalized traders and the general public. As would any field where the perceived benefits are concentrated but the costs widespread, HFT traders have formed special-interest lobby groups that will champion their cause, hiring former SEC staff members and was reported by the New York Times to have spent nearly $2 million in the last few years on Washington lobbying and contributions to lawmakers.

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Yet, research points to the fact that total costs for the industry as a whole is beyond and above total benefits and that whatever benefits exists in the practice is favorable to HFT traders but deleterious to others. That is why regulators are desirous of curbing their activities.

On every trading day, total order involves both executed trades and cancelled orders. What would happen if 95% of total orders were reported to be cancellations? This practice is called quote stuffing, a tactic of quickly entering and withdrawing large orders in an attempt to flood the market with quotes that competitors have to process, thus causing them to lose their competitive edge in high frequency trading. Quote stuffing creates congestion in order processing, makes small time investors worse off and is skewed against investors who have invested in stock trading over the years and are ready to stick with the market in times of stress. According to Mao Ye, a professor of finance at University of Illinois, quote stuffing has made stock trading a “purely positional game,” where the only winners are those who have invested heavily in high speed computers.

HFT trading has been dubbed an opportunistic practice that banks on the weakness of the system. According to Andy Brooks, head of U.S equity trading at T. Rowe Price: “My sense is that a premise for high-frequency traders is as follows: They generate an action simply to watch our reaction. Then they position themselves to profit from that reaction.” When they are needed most, in times of stress, when the market really needs liquidity, only institutionalized investors would be around to clean up the mess. If the market were to depend on speed for trading, then the whole game would just end in high costs and economic losses for everyone.

Not only does HFT depend on computing speed, but also monopolizing resources. Where the quantity of orders in the system are beyond optimal levels, that about 95% of the orders are created just to bait other traders, you can understand the huge costs in terms of time, pricing and positioning HFT trading is placing on other investors.

On the other hand, HFT traders contend they provide high liquidity to the market and cut down transactions costs in trading by narrowing the spread in prices. Gus Sauter, chief investment officer at the Vanguard Group, says their activity serve as a “lubricant” for the stock market’s engine . But Mao Ye doubts the claims of liquidity, and Matt Schrecengost, a self-professed high frequency trader and the COO of Jump Trading, believes that SEC cannot incentivize HFT traders in a May 6-like environment because they do not ensure the workings of the market, even cannot ensure market liquidity, in such a situation.

How SEC might likely regulate HFT as a practice

Eventually, as many studies have suggested, one way or the other, high-frequency trading might be regulated, if for anything, to reduce the huge externality it is creating in the market. Either SEC might regulate it using a tax or could place timed limits on orders.

Amongst the suggestions that have been posited by SEC is to place a limit on the minimum lifetime of any quote. This is termed the minimum quote life (MQL). SEC has suggested a MQL of 50 milliseconds. Within that limit, any order placed cannot be cancelled until after the 51st millisecond. Although no one knows if this is the appropriate MQL but a limit is better than nothing in order to reduce the huge social costs of congestion on orders.

Also, a tax or fee for cancellations could also be put in place, or if not possible, a tax on investment in speed could be more appropriate. Any of these taxes would lower the total orders in the market and skew the ratio in favor of executed orders away from the present high percentage of cancellations.

Whichever of these measures is implemented, or any that might be proposed in the future, it is important that SEC creates a level playing field on Wall Street and stop other investors from gaming the system.


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2 comments:

  1. "On May 6, 2010, the Dow Jones Industrial average plunged nearly 700 points in minutes before recovering. That event was tagged a “flash crash” and was blamed on high-speed trading on the floor of American stock exchanges. High-frequency trading (HFT) for the uninitiated, is the use of electronic trading platforms for entering trading orders using computer software."

    Incorrect. Read the SEC report:

    http://www.sec.gov/news/studies/2010/marketevents-report.pdf

    The flash crash was caused by a fundamental trader located in Kansas (who, was not on the floor of an American stock exchange. The closest stock exchange, BATS has never even had a floor).

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    Replies
    1. Thanks William. My sources for news stories are NYT, WashingtonPost etc. I think you misunderstood the article, especially how floor relate to stock exchanges. https://en.wikipedia.org/wiki/High_frequency_trading
      thanks anyway.

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