04.04.2014
By Terry Flanagan

HFT Reaches “Flash”-point

Michael Lewis, author of the new book Flash Boys, has succeeded not only in drumming up publicity for himself and his book, but in rekindling a debate that has been going on for the past 20 years, beginning with the Order Handling Rules and continuing through Regulation NMS (National Market Structure) in 2007.

The cumulative impact of these regulations has resulted in more liquid markets, while at the same time creating displacement within the securities industry by putting floor brokers and specialists out of work while creating new jobs for quantitative traders and technologists as algo trading desks, ECNs, and high-frequency trading thrived under the new rules.

“The U.S. has the strongest capital markets in the world and our regulated environment ensures fairness and transparency,” said a financial services industry source. “Misleading fiction about the operation of our capital markets…can severely harm investor confidence.”

In 1997, the SEC’s order-handling rules designated computerized trading platforms such as Instinet as electronic communication networks (ECNs). Within a few years of the order-handling rules, more than 10 new ECNs had entered the market, competing on price, speed, and reliability.

In 2007, Reg NMS (National Market System) required that exchanges handle electronic order instantaneously or else be branded a “slow market” that could legally be traded through, or ignored, by other market participants.

Since under Reg NMS, displayed quotes could no longer be ignored, new ECNs, such as BATS and Direct Edge, were formed as consortiums by the broker-dealer community, and they aggressively gathered liquidity.

The true picture of trading today is that of a spectrum with high-frequency trading at one end and manual trading at the other. Although some outliers exist, the majority of market participants have combined elements of both.

“We don’t think Michael Lewis was saying the stock market was rigged in the penny stock/boiler room way,” said Themis Trading principal Joe Saluzzi in a blog posting. “He was saying that the market was rigged because the overly complex system contains trapdoors and hidden passages which were designed for the HFTs to succeed.”

Aite Group’s recent research shows that cash equities electronic trading has become prevalent, but HFT has actually tapered and may be in decline in the United States.

“HFT has become commoditized in U.S. cash equities, and the search for alpha is leading to different asset classes and markets (e.g., Asia),” said Aite Group analyst David Weiss in a blog posting. “For regulators and prosecutors to now slam the door shut long after the horses have left the barn via some notable prosecutions after leaving the door wide open for seven years, rather than rebalancing market structure, would be a mistake.”

Weiss proposes to resolve these market structure problems by strictly enforcing margin requirements on all orders, synching the SIP (i.e., NBBO) with all market data, and an SEC pilot program in U.S. cash equities to limit any market-making to DMMs via quotes (i.e., no quasi-market-making via orders) on the 50 most liquid securities for one year.

Featured image via DCP

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