Are exchanges and brokerage houses the new deep pocket targets?

April 25, 2014 09:25 AM

High frequency trading has been a controversial subject for several years now but it has mostly been an “inside baseball” type of story for people involved in trading equities, options and to a lesser extent futures.

There have been questions about the propriety of exchanges offering co-location to their servers that actually execute the trades. But for a large group of end users, there are folks that place a high priority on speed and those longer-term traders who do not, co-location is a tool that may or may not be necessary to them. Most futures brokers see it as a necessary cost even if they are not getting a great deal of their business from so-called “high frequency traders.” It is better to be faster, even if your trading model does not depend on it.

Some end users do not like the way electronic trading has evolved but only partially blame this on high frequency trading. The use of devices like “iceberg orders” make it difficult to see what the actual size is in the market. Some old-time traders prefer the certainty of being able to get off size even if it means giving up the edge.

The most troublesome aspect of Michael Lewis’ book “Flash Boys: A Wall Street Revolt,” is it oversimplifies a complex subject and grossly mischaracterizes the players. Lewis continues to go on interview shows and claim that there is “scalping” going on as if it is some kind of a crime.

Some analysts acknowledge that there is some predatory behavior going on by some high frequency traders but that they also provide liquidity to the markets. Someone needs to inform Lewis that scalping would be the good kind of high frequency trading not the predatory kind as he continues to misuse the term.

Many market experts in criticizing the book point out that today’s equity markets are much cheaper and fairer for end users. Their execution costs are much lower and the spreads are much narrower.

But the folks who are in a tizzy over the so-called revelations in the book don’t know this history—even some in the regulatory world who should know—and are clamoring for reform and investigations and now the inevitable lawsuits are being filed.

First came a lawsuit against CME Group, which seemed a little misplaced as most of the revelations in Lewis’ have to do with equities and many of  the issues surrounding the problems of HFT are specifically due to certain Reg NMS mandated structures of equity markets.

But last Friday Providence Rhode Island filed a class action suit against a numerous exchanges and brokers over high frequency trading practices.

My initial reaction was—boy this “Flash Boys” controversy is getting out of hand as lawyers are jumping to file suit based on a book that is more art than science.

And where do we go from here? Nearly every municipality and taxing district of any size and every state has public pension plans that are highly invested in the stock market. Can they all sue? This would put that whole tobacco industry settlement to shame. And perhaps that is the gleam in some attorney’s eyes.

But is there something more to this than greedy lawyers trying to cash in on a controversy? Perhaps that is beyond my pay grade to decide but the suit has already been modified as it threw its net out a little too broadly by naming OneChicago—the single stock futures exchange that launched with much fanfare after the Commodity Futures Modernization Act of 2000 repealed the Shad-Johnson Accord, which banned futures on single stocks and narrow based indexes.

“No high frequency trading firm has done a trade or is connected to us,” says David G. Downey Chief Executive Officer for OneChicago. Downey called OneChicago being named in the suit “a case of mistaken identity,” based on it holding a Securities and Exchange Commission code 6 registration.

It does bring up the issue of a lack of care and due diligence. Lawsuits are expensive and require time, energy and money to defend even if it is simply having a lawyer point out an obvious mistake.

A lot of folks—many who should know better—have jumped on the controversy surrounding HFT that erupted with the publication of Lewis’ book and accepted some pretty serious charges as fact.

But as it concerns OneChicago, the folks in Providence simply said—à la Emily Litella—never mind.

On Monday, April 28, you will be able to see how some industry experts have responded to the controversy as we go live with the May issue of Futures, which includes a virtual roundtable on the HFT controversy.


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