07.16.2013
By Terry Flanagan

Regulators Eye HFT on Exchanges

High-frequency trading brings with it the potential to impair fair access on exchanges, the aspired-to state in which all market participants have a fair shake in getting the best possible execution for their trades.

Regulators’ challenge is to determine whether high-frequency trading impairs fair market access, and if so, what should be done about it. The task is complex: there are gray areas associated with HFT (indeed, there are lingering differences of opinion even about how to define the trading methodology), and exchanges have evolved from trade-matching venues only, to offering a host of auxiliary products and services designed to improve trading performance.

Rule makers in Washington have signaled that currently, the jury is out.

“High-frequency trading, complex trading algorithms, dark pools, and intricate new order types raise many questions and concerns,” U.S. Securities and Exchange Commission Chairman Mary Jo White said in a March speech. “Are they problematic for retail and non-institutional investors? Do they result in unnecessary volatility, or create an uneven playing field? Or do these modern-day features bring benefits such as efficiency, price reduction, and healthy competition to our markets?”

Mary Jo White, U.S. Securities and Exchange Commission

Mary Jo White, U.S. Securities and Exchange Commission

“The experts and studies to date have not been consistent or definitive in their observations and findings about whether and to what extent harm is caused by the current market structure and practices,” said White, who spoke as a nominee, a month before being sworn in as chairman. “There must be a sense of urgency brought to addressing these issues to understand their impact on investors and the quality of our markets so that the appropriate regulatory responses can be made.”

Ensuring fair access for all market participants and an absence of bias on the part of market operators is a primary concern for regulators, who spend considerable time looking at the issue from multiple angles, said a person familiar with regulators’ thinking on the topic.

Specifically regarding high-frequency trading, there are two ways a trader can obtain an advantage on an exchange, one problematic and the other seemingly not problematic, according to the regulatory source, who spoke on condition of anonymity.

If a high-frequency trading firm were to give tickets to a sporting event or other material token in exchange for higher speed throughput at a trading venue, that would be unacceptable, noted the source.

But if an HFT firm pays an exchange for 20 ports and a less-active institutional trader pays for two ports, the advantage that comes with the additional throughput seems fair and non-discriminatory, as the charges are reasonable and related to service use.

“This is where the heart of the issue lies,” the regulatory source said. “As exchanges innovate and offer more services, if not everybody wants or needs the services, you wind up with a whole host of different players operating with different methods and at different levels, timescales, etc.”

“In an exchange marketplace, all market intermediaries fight to outperform everybody else,” the source said. Regulators need to determine whether a situation is biased and unfair, or if it’s a matter of certain market participants gaining a leg up by opting in to a higher tier of exchange services.

A broader issue is whether having a diverse set of market participants operating at different speeds is good or bad for the market. That question is more subjective and difficult to answer compared with specific situations pertaining to fair market access, and it is not currently a front-burner issue for regulators, our source indicated.

Market Views
Market observers hold varying opinions on what regulators should or should not do with regard to how exchanges host high-frequency trading.

Eric Hunsader, founder of trading-software developer Nanex, said high-frequency traders’ advantage on an exchange is a function of their direct data feeds being faster than consolidated feeds, and regulators need only reference a landmark 2007 financial ruleset for how to even the playing field.

“Regulation National Market Structure spells out exactly what the regulation is for direct feeds and whether or not they have a speed advantage. All the regulator has to do is read Reg NMS, follow it, and enforce it,” Hunsader told Markets Media. “It’s kind of pointless to come up with new regulations when the existing ones aren’t enforced.”

Limiting HFT via speed restrictions or the like hasn’t gained traction, but other ideas such as capping order-to-trade ratios could be a more viable path for regulators. “There are some things they can do,” said Rich Repetto, principal at Sandler O’Neill. “It’s surprising the SEC hasn’t done anything yet.”

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