HFT ON TRIAL.
Dan Barnes assesses the clampdown on HFT.
Germany’s decision to regulate high-frequency trading (HFT) is almost unique in developed capital markets. While some are hostile because they lack the infrastructure to support HFT, the country is ahead of the pack in actively clawing back the advances of technology-led trading.
In the US, HFT accounts for around 63% of cash equity trading volume compared to Europe where the figure is closer to 40%, and in Asia 25% according to research by market consultancy GreySpark. Interfering with such a significant proportion of trading could reduce liquidity and increase volatility. However regulators must also ask whether the scale of HFT volume may be threatening market stability.
Paul Squires (see Profile, p.14), head of trading at buy-side firm AXA Investment Management, says, “Some HFT firms cancel close to 90-95% of their orders, pinging in and out of different markets then withdrawing liquidity. Some of the descriptions of this such as layering or ‘quote stuffing’ have negative connotations because that activity quite closely resembles price manipulation. You cannot trade against those orders but they affect the price you think you can trade at.”
Trading at high speed can also create spectacular mistakes. On 23 May 2013 NYSE saw a sell order in two energy companies trigger a ‘flash crash’ that cost investors $1.7m. Sellers traded 200,000 stocks at prices down to 63% below their value for less than a second, before trading returned to normal prices.
During the flash crash of 6 May 2010, which saw the Dow Jones Industrial Average Index drop 1000 points in 20 minutes before bouncing back, the Securities and Exchange Commission (SEC) and the Commodity and Futures Trading Commission (CFTC) identified the huge bursts of activity and withdrawal of liquidity by firms operating HFT market-making strategies as a catalyst for the crash. At one point these firms traded 27,000 equity futures contracts at such a speed they generated 49% of the day’s trading volume in 14 seconds, which caused many automated equity trading systems to freeze due to the extreme activity.
Since the 23 May flash crash the New York Stock Exchange has implemented a circuit breaker to cover the 15 minutes of market open and 30 minutes of market close that are not covered by the cross-market circuit breaker that regulators are enforcing. However other exchanges are still exposed in these periods and the event is symptomatic of the threat that markets face says Joe Saluzzi, co-founder of equity broker Themis Trading.
“[The 23 May crash] looked like an error rather than malicious, but it could easily have involved more stocks, it could have been a bigger error or a programme trade that came through and where was the protection?” he asked. “Years after the 2010 flash crash?”
However high-speed trading is not always HFT. When the Australian Securities and Investment Commission (ASIC) investigated HFT and dark pools it found that HFT was not a major contributor to market disruption, while market fragmentation and dark pools were. In a report issued on 18 March 2013, it noted that a variety of automated traders could be found demonstrating behaviours that are complained about such as pinging, and that HFT firms do not appear to rest orders in the book for very short periods of time.
“When we trade via algorithms the smart order routers break up our block orders into small quantities: it is intended to look like any other (non-institutional) order flow to avoid attracting attention,” says Squires. “So I can understand why regulators might wonder – when asked how to define HFT – whether algorithmic trading is really any different.”
Indeed the rules do not always distinguish clearly between the two. For example, the European Commission’s draft proposal for MiFID II demands that firms trading with algorithms should provide continuous liquidity, in an apparent reference to market makers and defines HFT as placing large volume orders based on high-speed analysis of market data.
The blurred line between HFT and other electronic trading and a lack of empirical evidence to connect it with either market abuse or disruption, has stirred concerns among market observers about the effect of regulatory interference.
Brad Wood, partner at GreySpark says, “I think we have seen some knee-jerk regulatory responses to the flash crash made by politicians who frankly have no idea how these markets operate.”
The first step
On 15 May 2013 the German market regulator BaFin created a regulatory regime specifically for HFT firms. It defines them as those which use co-location and high-bandwidth lines (10 gigabytes) to trade; which initiate orders without human intervention; with more than 75,000 orders placed per day; and with a high order cancellation ratio. These traders will have to be licensed by BaFIN if they are a participant with the German market either directly or indirectly, including firms that access the market electronically via other market participants.
Licensed firms must hold at least €730, 000 in capital and have to make sure their trading systems are resilient, are operating within the trading and risk parameters, have the capacity needed to cope with their activity, do not send erroneous orders or disrupt orderly market function, market abuse regulations or venue rules and have business continuity plans in place to prevent operational failure.
Trading venues have to tag orders generated by algorithms, set limits on order to trade ratios and message volumes, with levels appropriate to the assets being traded and their characteristics.
Any trading firm that place orders to fix artificial price levels; disrupt or delay the functioning of the trading system; to make it difficult for third parties to identify genuine purchase or sell orders in the trading system; or to create a false or misleading impression about the supply of or the demand for a financial instrument, will be considered market manipulation whether or not the algorithm that places the orders is engaging in HFT or not.
At least one firm is reported to be shutting down as a result of these rules. Cologne Independent Traders, which operates in Germany and Switzerland, describes itself as a specialist in Delta-1 trading with a focus on stocks, commodities and futures and exchange trading funds (ETFs) is expected to shut before the end of the year.
Crest of an international wave
BaFin is one of the first regulators globally to introduce these rules but many others are close on its heels. In Asia, HFT is only viable in a few markets but policymakers are aggressively imposing frameworks to help them avoid the sort of events seen in the US.
Meanwhile, ASIC is in the process of introducing rules to give market operators better control over extreme price movements, by using automated trading pauses which will extend to the ASX SPI 200 Futures market and enhanced market participant filters and controls for automated trading, which will include a ‘kill switch’ to immediately shut down problematic trading algorithms.
It also charges trading venues a levy based upon the amount of message traffic that it has to manage to monitor them.
Taxes on equity trading in Korea make HFT non-viable, but its derivatives markets rely hugely on HFT. Joon-Seok Kim, research fellow in the Capital Markets Department at the Korea Capital Market Institute, has identified that firms posting 1000+ orders a day on a single instrument in the KOSPI200 Futures and Options markets make up 50% of daily volume.
The Korea Exchange (KRX) released a consultation to regulate electronic trading of derivatives on 29 April 2013. Under the proposal it would require firms to register their trading accounts, which will have kill switches allocated to them to prevent algos going awry.
The exchange will be able to refuse ‘excessive’ numbers of orders and can charge firms that post excessive numbers of orders a fixed fee of KRW 1,000,000 per month. The ratio of orders to trades was set at 20-1 if the number of orders is between 20,000 and 100,000 and 10-1 if the number of orders exceeds 100,000.
MiFID II, the pan-European directive currently being debated and expected to take effect some time in 2016, will follow the line of the German rules but could go even further, imposing a minimum resting period for orders and order to trade ratios.
Sand in the wheels
The European line would be to make HFT less viable. However targeting a trading style without identifying specific problems it has caused would appear to be unfair on HFT notes Magnus Almqvist, senior business development manager at technology provider SunGard.
“You do find harmful trading patterns that fall under the HFT umbrella just as you do under any trading method,” he says. “When you had floor trading there were unacceptable methods on the trading pit.”
Squires observes that the key in distinguishing between algorithmic trading and HFT is in addressing the trade to execution ratio.
“In my opinion, imposing a trade to execution ratio and minimum resting times would be effective ways to keep an orderly market,” he says.
Alternatives to banning HFT should also be considered says Sébastien Jaouen, head of global trading sales at Etrali. “In a nutshell, with the huge progress we have witnessed in the capturing of all communication pieces and the ability to reconcile them with the full audit trails of orders and trades, the regulators have the tools and power to enforce the regulations and track fraud,” he says. “The technology is an enabler not only for market participants such as HFT but also for the regulators.”
Wood notes that that some rules are likely have unintended consequences which could be more detrimental to the orderly functioning of the market than positive, while they are not guaranteed to prevent the firms operations entirely.
“HFT firms are nimble,” he says. “There is a bit of cat and mouse going on as the regulators will follow behind but I think there will always be a response in the HFT community, they will still be able to identify profit-making opportunities.”
© BestExecution 2013