Knight Capital and keeping HFTs honest

Sometimes the only thing worse than slippage is a lack of slippage. If you are 18 bid for 1,000 with the hope of actually selling 19s, it can be disconcerting to get hit on your 18s and have a local offer you 1,000 more.

While electronic trading has helped the markets grow that is perhaps the one thing missing. A large player keeping things honest; hitting that odd bid or lifting that odd offer that appears to be nothing but a loss leader. With all the iceberg orders and algos out there someone to let you know that if you place in order it may be hit or lifted.

HFT is not monolithic and its effects are different depending on the market structure. It is a completely different thing in securities markets, which allow payment for order flow, internalization and maker taker rules and the futures markets with pure price time priority. Perhaps that is why it is more prevalent in securities markets. But the rule is that each order and each trade is exposed to risk.

Shortly before Knight’s faulty algorithm cost them $400 million, the Futures Industry Association’s European Principal Traders Association put out a paper titled: Market Integrity Framework: Best Practices to Preserve Market Integrity.

In it they stated that “Market manipulation can be characterized by any of the following: 1) Transactions or orders that give a false or misleading signal or secure the price of a financial instrument at an artificial level; 2) Transactions or orders that employ fictitious devices and/or other forms of deception or contrivance; and 3) Distribution of information likely to give false or misleading signals.

This seems like a logical framework for regulators to work with. Every order must be exposed to risk. When bandwith was a concern some exchanges floated the idea of charging a fee per order into the market. Perhpas that could be reexamined? Perhaps market structures that advantage whether you are a market maker or taker needs to be looked at, particular in liquid markets that execute, hundreds, even thousands, of transactions per second. In such a market there is little need to provide incentive to place resting orders.

When payment for order flow became prevalent, there were traders that created programs that would be successful simply based on that. One thing we know about traders is that they will breakdown any market structure, any matching algorithm, to find an edge. That is why the simplest most straight forward, most transparent rules are best.

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About the Author
Daniel P. Collins

Editor-in-Chief of Futures Magazine, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange. Dan joined Futures in 2001 and in 2005 he was promoted to Managing Editor, responsible for overseeing all the content that went into Futures and Dan’s incisive reporting and no-holds barred commentary places him among the most recognized national media figures covering futures, derivative trading and alternative investments.

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