01 Feb Clear and Present Danger
Back in November, the UK’s Foresight Committee released its findings on “The Future of Computer Trading in Financial Markets”. In a nutshell, the findings reflected a pragmatic view of the dangers of HFT and raised some practical approaches to making markets safer for everyone – circuit breakers, consolidated tape and what have you. I found the paper balanced but inconclusive; not the end of the discussion but a better starting point than we’ve seen to date. What is clear from the paper is that working with HFT to address perceived dangers is the committee’s preferred approach over banning HFT outright.
It seems that Edward J Markey, Member of Congress in the US, disagrees.
Congressman Markey, in a letter to the SEC on 18th January, declared that HFT “represents a clear and present danger to stability and safety of [US] capital markets and that it should be curtailed immediately”
Direct and to the point.
Congressman Markey backs this assertion with evidence drawn from market events, such as the Flash Crash and Knight Capital, as well as academic studies on the impact of HFT on markets and therefore main street. If I can synthesize his argument, essentially he states that:
1. The speed of HFT disadvantages other styles of trading
2. HFT exacerbates volatility in the market
and as a result
3. ‘Other’ investors are scared away
4. Volume traded by HFT is therefore a dangerously high proportion of overall traded volume
While I favor “working with HFT to address perceived dangers”, I have to say I see a thread running through the Congressman’s letter that I both agree with and, like the Congressman, find disturbing.
While most HFT is actually just normal-trading-but-very-quickly, HFT strategies typically profit from very short term pricing anomalies between 2 or more products or liquidity sources. Volatility in the market as well as market fragmentation and the lack of adequate consolidated price feeds in some (many) markets generate these anomalies and make it easier for HFT strategies to succeed. In fact you might argue engineering volatility – at the very least exacerbating it – is in the interest of HFT strategies.
As someone who is primarily concerned about the performance of long-only funds and future planning this sounds unnerving but it’s actually OK (just about OK that is) if the volume traded by HFT is a small percentage of the total market. It’s a faint background noise. However, when HFT becomes a large, or even dominant, force in the market then ‘Other’ investors genuinely do have a reason to stay away. Who wants to play in a market where movement for movement’s sake has overtaken fundamentals. No thanks, I’ll let the HFTs spar in a zero sum game or volatility ping pong and stick my cash under the mattress.
The same is true incidentally when commodity markets become overrun with speculators. The price of a commodity ceases to be about supply/demand from real-world businesses who rely on physical commodities and becomes about profiting from volatility – which speculators have an interest in exacerbating.
The problem I have with Congressman Markey’s position is not the analysis of the problem but his proposed solution – to ban HFT outright. What does that mean? Ban automated trading that occurs faster than some arbitrary speed limit? Ban automated trading that is based on very short term positions? Ban automated trading full stop? No, that’s not going to work. For a start there are many benefits to automated trading such as efficient execution algos replacing a highly manual (and very expensive) task. And there are a great many grey areas between different automated trading motives and techniques and if we can’t agree exactly what HFT is how can we ban it?
What I think Congressman Markey fails to understand is that there are actually very well defined terms for some of the behaviors he fears most, as a well as a mountain of regulation to prohibit those behaviors. HFT is, after all, normal trading but quicker. If any market participant, high frequency or otherwise, attempts to move the price of an instrument (aka price ramping) by dominating the market (aka abusive squeeze), it is market manipulation. If said participant takes the position with the sole intention of immediately reversing it (flipping) for profit, or indeed to engineer volatility, it is market manipulation. These are well understood dangers of any style of trading and apply equally to HFT. To suggest banning HFT is to not understand that it’s the behavior that is wrong, not the speed at which is takes place.
So I would suggest to Congressman Markey, that what is needed is not a ban on High Frequency Trading but a mandate for High Frequency Market Surveillance, preferably in as near real-time a possible so humans can respond to manipulative algos in timeframes less than minutes or hours or days or never. Who knows, a technology may even exist to apply an automated kill-switch to algos that are misbehaving, be it in a manipulative or simply erroneous manner.