Impact of HFT regulation on markets

Financial Times today:

EBS, one of the two dominant trading platforms in the foreign exchange market, is suggesting scrapping the principle of “first in, first out” trading, which it says gives an unfair advantage to the fastest computers and has led to an arms race of spending on technology.

Instead, under the plan, incoming orders would be batched together and dealt with in a random order.

For now, let’s ignore the question whether any regulation is necessary, and discuss the impact this particular change of rules will have for the market microstructure if they were accepted universally.

Liquidity providers, i.e. market makers, will have a harder time figuring out their priority in the order book and may be exposed to pick-offs of resting orders in the case of a news event – depending on whether cancellation messages are prioritised over trade messages by the exchange. Bid/ask quotes can only widen based on these new regulations.

Trade agressors, i.e. market takers, will have less benefit of an advantage in speed. Any self-respecting trading firm can get their orders to the exchange in milliseconds, so when multiple firms run similar strategies (and they certainly do), speed won’t be the deciding factor anymore. These regulations are effectively discouraging competition and will lead to a more level playing field among HFT firms and thus to a slow-down in the technological arms race.

It is up to the regulators and exchanges to decide whether the wider bid/ask and the forced reduction in competition justify the cost savings. Personally, I am all for free markets and wouldn’t regulate when it isn’t needed – but this proposal is as feasible as I’ve seen. It’s certainly a less ludicrous idea than introducing a financial transaction tax or a minimum holding period.

Please stop blaming HFT for the Flash Crash that never was

After the tweet-hack incident last Tuesday caused a one percent down spike in S&P futures, it was only a matter of time before the perpetual pessimists at Zero Hedge, ignorant NBA team owners and retail punters would blame high-frequency traders for all that is unfair in the current marketplace. Nothing new there. What caught my eye is that some of the more nuanced and respected bloggers were clinging on to this idea too: the Flash Crash of 2013 was born. Josh Brown at The Reformed Broker mentions:

‘[HFTs] provide a glass of water in a monsoon, but when you really need them to absorb sell orders, they’re on the sideline, buffering. It’s a joke.’

And I’m not even sure what Howard Lindzon (founder of StockTwits) exactly means with the following sentence – and who he wants to punish – but it’s safe to say he’s not happy:

‘I don’t like the idea of hackers and market manipulation, but if this is what it takes to get the algo’s away from the machines with their bullshit bids and false sense of liquidity, all the better. We need to punish these type of hackers with as much speed and breadth as we can.’

After the release of the infamous AP tweet, 175 million twitter users can read that the White House has been attacked and President Obama might well be dead. Every prop desk, hedge fund and anyone with an e*trade account and a twitter feed is one mouse click away from selling the S&P future. And somehow, at this point, it is expected of HFT firms to keep their bids in the market and ‘absorb the sell orders when you really need them’? I would like to call double standards on this one. For all we know, the leader of the free world has been attacked, and simply because HFT trading firms are ehm.. HFT firms (?).. they are supposed to buy your S&P futures? Using technology and social media to gather information is great, but acting upon new information to avoid trading losses is ‘a joke’?

Regarding that disappearing liquidity: have another look at that much referenced Nanex chart. What commentators seem to ignore is that people who really wanted to get their trade done managed to do so, as indicated by the spike in trading volume. The 1% up and down move was on the back of 300,000 contracts – almost 20% of the day’s volume in a matter of minutes. Seems like decent liquidity to me. Sure, the slippage may be bigger than usual, but oh yeah, let’s not forget that THE PRESIDENT HAS JUST BEEN ATTACKED.

Bloggers and journalists seem to idealise a sort of utopian past in which all trades got done at mid-market, with unlimited levels of liquidity at any point in time, and a complete lack of market manipulation – a world that supposedly ended with the rise of the evil HFT firm who does nothing but stealing your money. Think about the ultimate carnage that would break out on the NYSE floor after the release of such a news message. No floor trader would honour their bids and everyone will scramble to get short – most likely against their own clients.

There is nothing else the HFT guys could have done other than pull their resting orders. Any real-person trader would have done the same. Even though HFT algos are programmed by Physics PhDs, their thinking isn’t very different to those old school floor traders. It’s mainly the execution that has evolved, the basic market making strategies not so much. It is pretty easy to program the behaviour of traders in calm market surroundings as their instincts are fairly predictable. However on unexpected, never-seen-before occasions as these ones all predictability goes out the window – and so does the algo. Innovative human thinking has to take over at this point; which it did. That is why the S&P future went down when everyone thought a disaster had happened, and why it came back up when it was clear that there was no disaster.