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Louis Lovas
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Capital Markets in Transition, Regulators on Watch

The promise of returns and threat of catastrophic failure is pushing trading firms to the edge.

Louis Lovas, Director of Solutions, OneMarketData
Louis Lovas, Director of Solutions, OneMarketData
The days of easy money are long over. Technology is transforming trading styles as algorithms create a more competitive environment and exponential growth in data volumes. As the number of firms deploying algorithms increases they will be chasing after a diminishing pot.

Algorithms offer the promise of strong returns and likewise render a threat of catastrophic failure. Competitive pressure has pushed trading firms to the very brink, and for some over the edge. And the fallout, manifested in the flash crash, failed IPO’s and bad code wreaking havoc will be a major driver in the coming year for regulators and those whom they look to control.

Below are handful of reflections and expectations for the coming year on algorithms, HFT and regulatory impact.

1. Ensuring software stability will be a major focus across all Trading firms, Asset managers and Exchanges

Market participants are confronted with a sea of imposing forces. They range from increasing competition, escalating market complexity and regulatory compliance and living in the wake of numerous high-profile software glitches that have plagued the industry over the past few years. All the while technology is making a sweeping transformation in trading speed and complexity from the accelerating use of algorithms across markets, which are increasingly fractured into lit and dark liquidity.

As Larry Tabb recently commented, “… at the heart of our markets is the idea of fragmentation and speed.” And dark liquidity now account for over 40% of traded volume. Even Jim Cramer laments about the push and pull of macro and micro forces, “… the macro tug of events, the impact of important economic influences, like jobless claims or pronouncement by the Federal Reserve… and the micro, the individual news coming out of individual companies…”. Combined, the resulting market gyrations are like pressing on the gas and the brake at the same time.

Regulators are watchful as technological change blankets the industry. They wrestle with fears of systemic risk in the technology fallout manifested as mini-crashes, IPO mishaps (e.g. Facebook, BATS) and rogue code debacles (e.g. Knight Capital). Consequently, the SEC and CFTC are accelerating rule oversight for managing technological risk. RegSCI (Regulation, Systems Compliance and Integrity) is a direct consequence of these hazards, designed to enforce policy for software testing.

The opposing forces facing market participants is rapidly deploying new and revised profit-seeking strategies against the fear of being headline news as the latest rogue algo to wreak havoc across the markets. The consequence will be to err on the side of caution. If not due to regulatory mandate, through their own volition, trading firms will increase and expand their software testing.

That begins with unit testing through integration testing and acceptance testing – robustness is an attempt to measure stability and durability of an algorithm. It is determined by replaying historical data through algorithmic logic and trading to a simulator, a scaled down replica of an exchange’s matching engine.

The center piece to this will be data, data management and cloud storage. History can represent normal market activity, highly volatile conditions even crash periods. Semantically an algo’s logic should behave gracefully to turn a profit, avoid a loss or exit the market. Analyzing test results is a hunt for regressions and validation to ensure stability and ultimately a trading firm’s long-term viability.

2. The winners and losers in the shrinking HFT market (the HFT ecosystem falters)

Although high-frequency trading (HFT) has matured in the past decade, there are still fundamental arguments around what it is and what it does. A simple case-in-point, latency is an important aspect of all algorithmic models from alpha-seeking to complex order execution not just HFT. It is not a simple matter to peg all high-speed trading as HFT.

Nonetheless, HFT critics across the globe have leaned hard on regulators to propose countless measures for slowing down high-speed traders; taxes, cancelation fees, order duration rules, increased tick increments, the list goes on-and-on. For the last few years HFT’s returns per trade are minuscule fractions of a penny. According to Justin Schack at Rosenblatt Securities, HFT has been on the decline for last 4 years.

Under the constant threat of regulation firms have retreated. The evidence is in year over year income (loss) of high-profile trading firms such as Getco and Knight Capital. That decline in recent years can be viewed as a leading indicator of a fragile ecosystem dependent of the success of this industry.

An entire cottage industry grew up feeding the frenzy that was the HFT market. That ranged from hardware infrastructure vendors to the software stack focused of squeezing out every errant microsecond of latency in the tick to trade food chain. Vendors leveraged bleeding edge technologies for network routing and messaging and many did their best with multicore CPU’s for parallelizing trading logic.

The low latency and high-performance demands of algorithmic trading will not disappear, but transition to the next-phrase likely centered on more sophisticated mathematical models. You cannot put the genie back in the bottle, today’s HFT trading systems will transform to whatever the new regulatory regime that emerges from the dust.

Yet the downhill slide of HFT will most likely take a lot of players down with them as the latency war is fought on a different battleground. This should be a critical consideration, as HFT is hunted to extinction so goes the industry’s ecosystem.

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