In January 2013, Edward J Markey, Member of Congress in the US declared that High Frequency Trading (HFT) "represents a clear and present danger to stability and safety of [US] capital markets and that it should be curtailed immediately."
Congressman Markey backs his 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. To summarize his points:
1. The speed of HFT disadvantages other styles of trading
2. HFT exacerbates volatility in the market
3. 'Other' investors are scared away
4. Volume traded by HFT is therefore a dangerously high proportion of overall traded volume
Not everyone shares Congressman Markey’s view. I was involved with a UK government-sponsored expert group called Foresight, which released its findings on "The Future of Computer Trading in Financial Markets" last November. And Foresight’s findings were quite different! Foresight does not feel that HFT increases market volatility and raised some practical approaches to making markets safer for everyone, including circuit breakers and a consolidated tape. Foresight favored working with HFT to address perceived dangers is the committee's preferred approach over banning HFT outright.
[Knight Capital's trading glitch has spurred a great deal of discussion about market regulation: Will Knight Capital's Trading Disaster Hurt Market Confidence?].
So where does the truth lie? Well I must admit, despite the hyperbole, the Congressman makes some good points. I just don’t agree with his conclusion about banning HFT.
I must admit, despite the Foresight evidence, I struggle to think that HFT does not add to market volatility. 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.
I’m not convinced true HFT is such a large part of the market. Yes electronic automated trading is – but not necessarily HFT. This brings us to another floating issue: how to define HFT. I serve on the CFTC Technology Advisory Committee and our chair Commissioner Scott O’Malia has been trying to get a good definition of HFT bashed out for quite a while. He’s now got one, which is essentially “fully automated super speedy, short holding time;” but is this Congressman Markey’s definition?
If what we define as HFT is a small part of the market then that’s OK, as it’s a faint background noise. However, if HFT becomes a large or even dominant force in the market then 'other' investors genuinely do have a reason to stay away. No one wants to play in a market where movement for movement's sake has overtaken fundamentals.
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. For instance, efficient execution algos have replaced a highly manually (and very expensive) task. And there are a great many grey areas between different automated trading motives and techniques. If we can't agree on the definition of HFT, 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, just quicker.
For instance, 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 a 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 a suggest banning HFT is to not understand that it's the behavior that is wrong, not the speed at which is takes place. The question is – do we have the ability to police trading at that speed?
One of my big concerns is trading algorithms going out of control – as we have seen many times, including at Knight Capital. This suggests a market not under our control. We must have better monitoring and control systems to prevent this from happening – or I become quite sympathetic with Congressman Markey’s views.
So I would suggest to Congressmen 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 time frames in rapid fashion (not 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.