High frequency trading (HFT) of securities has become a high-profile target on both sides of the Atlantic in recent weeks.
On September 2, Italy began imposing a tax of 0.02 percent on many order changes and cancellations that occur within 0.5 seconds of the original order. Later that month, the managers of the world’s largest sovereign wealth fund (SWF), Norway’s $803 billion Government Pension Fund, raised questions about the extent to which HFT truly adds liquidity to markets and whether the technology and complex algorithms employed in HFT enable traders to game the system. And in the U.S. late last month, a group of Wall Street veterans launched a new alternative trading system (ATS) with infrastructure, technology, and operating policies designed to protect investors from the “predatory trading” and other inequitable practices alleged by critics of HFT.
Some context is important here. In many people’s minds, most stock transactions continue to take place on crowded trading floors in lower Manhattan, the City, and other financial centers, with traders shouting ask and bid prices to one another and striking deals in a cacophonous frenzy that ends only with the sounding of the closing bell. That is a Norman Rockwell portrait of the markets – vivid, endearing in its focus on people hard at work, and an idealized depiction of a bygone era. Today, the overwhelming majority of stock trades are executed electronically, and anywhere from 50 percent to 70 percent of all transactions are attributable to high frequency trading. With HFT, traders employ sophisticated algorithms and near real-time data feeds on market trends to place and sometimes change orders in intervals that are measured by fractions of seconds.
Proponents of high frequency trading argue that the technology and protocols powering their approach make for highly efficient and liquid markets, matching buyers and sellers almost instantaneously, while rapidly discerning trends that enable them to make trades that are in clients’ best interests. They add that the development of the technology platforms that support HFT have freed investors from dependence on traditional stock exchanges, driving down commission prices by providing alternative means of executing trades. As for allegations of unfair practices, they note that the worst alleged abuses, which entail charges of market manipulation to bid up prices artificially and of intentionally slowing down market operations to some traders’ benefit, have not been proven. They add that in stock trading, as in every endeavor, those who innovate and develop more-efficient processes rightly reap the rewards of their efforts, and that this creates a competitive environment that promotes progress and is good for society overall.
Indeed, the rise of HFT is a result of both technological advances and legislative efforts to foster greater competition in equities markets. Starting in 1997, the United States adopted a series of laws and administrative rules that undercut the predominance of the New York Stock Exchange (NYSE) and over-the counter NASDAQ market. Many European nations took similar steps. As a result of that regulatory impetus and of digital developments that facilitated virtual trading, today there are 13 U.S.-based exchanges and more than 40 so-called “dark pools.” The Financial Times defines these pools as networks “that allow traders to buy or sell large orders without running the risk other traders will work out what is going on and put the price up, or down, to take advantage of the order.” The FT goes on to note that the pools, “have been criticised for their lack of transparency and because the inevitable fragmentation of trading could lead to less efficient pricing in traditional open stock exchanges.”
That lack of transparency is one of several negatives that critics cite in arguing that HFT does not serve the overall interests of the market. They charge that high frequency trading can increase market volatility. They note that investigations found that HFT contributed to the so-called “Flash Crash,” of May 6, 2010, when the Dow Jones Industrial Average experienced its largest intra-day decline – 998.5 points, or about 9% of its value – before recovering a few minutes later, and that it also has been implicated in other short-lived market gyrations. They maintain that the liquidity that HFT claims to bring to markets often is transient and of no practical value because it merely reflects transactions made and then cancelled or altered in well under a second. Most seriously, they charge that the technologies and fee structures employed in HFT can create a tilted playing field and allow unfair practices. By “co-locating” their hardware and software in close proximity to those of exchanges, HFT traders can obtain data feeds fractions of second ahead of others. Critics charge that this information advantage enables “order anticipation,” in which high frequency traders identify signs that a stock-purchase order is coming into the system, “jump in front” of that order to buy the stock, and then sell the stock a few seconds later at a modest profit.
One of the most vocal critics of HFT as it currently is conducted is Joe Saluzzi, a veteran trader and principal in Themis Trading. Along with Sal Arnuk, his partner at Themis, Saluzzi blogs frequently on the topic and co-authored, “Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio” (FT Press, 2012). The book argues that an unintended consequence of the regulatory reforms that gave rise to HFT has been to make markets more opaque and more susceptible to practices and fee and rebate structures that favor one class of investor over others.
“Firms that engage in these practices will emphasize that what they’re doing is not illegal and not against the rules, and that’s true. They will tell you that anyone can co-locate next to the NYSE’s servers or use microwave equipment to shave a few fractions of a second off of data transmission, and – technically – that’s true. But the practical reality is that these firms take advantage of the way the system has been structured and developed over the last 15 years to pick off pennies throughout the day that can add up to millions and that – we feel – come out of other investors’ pockets. We’re pro-technology, but we feel that what they’re doing doesn’t add any value and in fact introduces a lot of noise into the system,” Saluzzi said in a recent interview with this blog.
The Wall Street veteran adds that while HFT led to an initial reduction in commissions, complex rebate deals that many high frequency traders offer selected customers can encourage essentially meaningless market activity while creating an uneven playing field in terms of transaction costs. “We need to get rid of this maker-taker model of rebates and make it a flat-fee structure,” says Saluzzi, who adds that the transformation of the traditional exchanges from non-profit entities to for-profit companies has exacerbated the problem by creating a mindset in which exchange operators are more attuned to the needs of bigger customers than others. Saluzzi, who with Arnuk eschews market-making activities and takes other steps to prevent conflicts between Themis and the institutional investors it serves, sees promise in an ATS launched in late October that avoids many of the practices that HFT critics say can lead to an uneven playing field.
The trading platform, called the IEX, does not allow brokers or dealers to be part owners, does not offer rebates or so-called “liquidity partner programs,” limits itself to four types of orders rather than embracing some of the more-complex orders offered by other platforms, and does not communicate its order information to subscribers. Many alternative trading systems sell such data, allowing subscribers to feed the information into trading algorithms. Perhaps most significantly given concerns about unfair advantages conferred by technology, IEX builds a 350- microsecond delay into its trades to minimize the informational advantage others might gain by identifying and quickly “jumping in front” of an order. While operators of other trading platforms have said the IEX approach is unlikely to have a significant impact, Saluzzi says the platform is taking several steps in the right direction. He also argues that exchanges ultimately should be run and regulated like public utilities, with recognized obligations to act transparently and to not favor any one class of customer over another.
While American financial executives are seeking technology- and market-based solutions to what they see as technology- and market-based problems, across the Atlantic, the Norwegians are asking questions and the Italians are imposing taxes.
Lest the Norwegian approach seem unduly passive, it’s worth noting that the country’s sovereign wealth fund owns roughly 1.3 percent of equities worldwide, so that – to paraphrase an advertising tagline from the Wall Street of yesteryear – when Norges Bank Investment Management (NBIM) asks questions, people listen. The questions being asked by NBIM, the division of Norway’s central bank responsible for administering the country’s sovereign wealth fund, include whether HFT brings meaningful liquidity to markets, whether it increases transaction costs and systemic risk, and whether it lends itself to market abuse through order anticipation and other practices. As is so often the case with carefully researched papers, NBIM’s 28-page “Discussion Note” on the subject contents itself with providing more questions than answers and calling for further inquiry into the issues. While that may not rise to the level of being a broad shot across the bow of HFT, it undeniably is a signal that a very big player considers these matters a very big deal.
Several hundred miles (er, kilometers) to the south, Italy has implemented its 0.02% tax on order alterations occurring in 0.5 seconds or less and on equity derivative trades. The tax applies to issues by Italian companies that have market capitalizations of €500 million, as well as depositary receipts and shares via convertible bonds. It will be levied regardless of where the trade occurs and who the parties are. It follows a broader financial transactions tax (FTT) enacted in Italy in March, and which levies a 0.22% tax on exchange-based trades and a 0.12% tax on over-the-counter transactions, although several exemptions apply. The taxes have been criticized on several fronts, with Italian companies and financial-services firms arguing that they will diminish the liquidity and competitiveness of Milan’s Borsa Italiana and neighboring countries angry that Italy has acted in advance of plans to implement an EU-wide FTT.
This is not the first time high frequency trading has been the target of scrutiny. Even before the Flash Crash of 2010, critics raised concerns about the opacity and fairness of HFT, but the complexity of the subject discouraged sustained public attention. Technologically flawed initial public offerings (IPOs) of companies including Facebook brought a renewed focus on HFT, as did an August 2012 problem with Knight Capital Management’s HFT programs that created a wild hour on Wall Street and reportedly cost the firm more than $400 million.
The main question now is which fixes – technological, market-structure, regulatory, or tax-based – will prove effective and which will introduce unintended consequences, as was the case with those well-intentioned efforts that gave rise to HFT in the first place.
