The regulatory conundrum
HFT presents different problems and serves different purposes depending on whether it is being deployed in futures or in equities. On the equities front, it often links multiple platforms and fills a role previously occupied exclusively by registered market-makers, who were obligated to make two-way prices. In futures, that type of market-making was never the norm, and HFT generally is seen as simply a newer, faster version of the locals who always traded in their own best interest, with tight spreads being a by-product. Not everyone, however, is buying it.
“I hear from a lot of people in the financial sector how the cheetahs, the HFTs, are nothing more than a variation of the old day trader,” said CFTC Commissioner Bart Chilton at a March 29 meeting of the agency’s Technology Advisory Committee (TAC). “What we have found out, and I found out, is that it is naïve for us, in general, not to question how technology is changing markets.”
Academics like Joel Hasbrouck of New York University’s Stern School of Business are questioning it, but the answers are mixed. He referenced several academic studies at the TAC meeting, all but one of which contained data that was more than a year old (and, in fact, were included in our story last May). The most convincing pro-HFT argument remains Albert Menkveld’s “High-Frequency Trading and the New-Market Makers,” which followed one major HFT on Chi-X and demonstrated that his activities narrowed spreads across several markets. The most disturbing study remains “A Dysfunctional Role of High-Frequency Trading in Electronic Markets,” by Robert A. Jarrow and Philip Protter, who modeled the behavior of HFT strategies in a stable market and found they first created market aberrations — which they then capitalized on and corrected.
Hasbrouck’s own study identified peculiar bids entering a market in a way that might be designed to manipulate the NBBO in equities but that clearly would be benign in futures. The United Nations Convention on Trade and Development released a disturbing piece titled “The Synchronized and Long-Lasting Structural Change on Commodity Markets: Evidence From High-Frequency Data,” which says that HFT might be distorting commodity markets by creating synchronous price moves detached from fundamentals.
Most disturbing of all, however, may be the tendency of HFTs to follow similar strategies — raising the question of whether some confluence of factors could trigger a runaway market event as HFTs run amok. Most traders dismiss that notion — in part because HFTs are short-term in nature, but also because traders with a more intermediate time frame usually step in when markets move too far one way or the other — as they did in the Flash Crash.
Hunsader, however, says that intermediate traders are backing away from the market at critical times lest they get tricked by HFTs (see “The race to the swift”), and that all the traffic being generated by HFTs gaming each other is raising the costs for those intermediate traders — accelerating their flight from the market.
“Our costs have gone up tenfold in the last few years on the equities side, while the number of trades and speed of trading have declined,” he says. “Last October, anyone processing stock quotes had to upgrade all their equipment from gigabit to 10 gigabit, which would be fine if this were due to an increase in meaningful data, but it’s not.”
That 10-fold increase in bandwidth, he says, translates into a 20-fold increase in cost, which could force intermediate-term traders out of the market.
“If this continues, we’ll end up with two groups of participants — those trading in milliseconds and the mom and pop investors,” he says. “That would mean a lot more volatility during the day, because you wouldn’t have diversity of opinion.”
While Hunsader’s concerns focus on equities, futures markets have messaging issues of their own — primarily when HFTs start generating and then canceling thousands of quotes away from the market. ICE began to address the issue in March by charging lower fees for orders placed within one or two ticks of a market and higher fees for orders placed three, five or more ticks away. The pricing mechanism only applies to traders who generate 300 or more trades per second; it isn’t designed to cut down on message volume so much as to promote the kind of messaging affiliated with HFT that leads to tight spreads, while still encouraging intermediate-term traders to place orders a bit further away to provide depth of book.