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Dr. John Bates
Dr. John Bates
Commentary
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HFT's Death by a Thousand Cuts

It took a while for regulators to catch up with high-frequency traders. Unfortunately for the HFT players, the regulators found their footing in September.

September has been a painful month for the high-frequency trading industry, as a series of seemingly small stories (and one big one) could be signaling the beginning of the end for the so-called “Flash Boys."

Here is the bad news so far:

  • The Securities and Exchange Commission imposes a $16 million penalty against an HFT for mismanaging its capital buffer or "haircuts" -- the SEC's first enforcement action against a high-frequency trading firm (WSJ, Sept. 17).
  • A hedge-fund manager accuses high-frequency traders of destroying his firm (WSJ, Sept. 4).
  • Three big law firms plan to sue major US stock exchanges for giving HFs unfair advantages to the detriment of regular investors (WSJ, Sept. 8).
  • NYSE Euronext pays a $5 million penalty to the SEC for giving HFT customers a head start on trading information (Bloomberg, Sept. 14).
  • The Financial Industry Regulatory Authority (FINRA) proposes a new set of aiming to make trading firms more responsible for their algorithms’ behaviors (Sept. 19).
  • A top SEC enforcement official said the agency is conducting a number of investigations into potential market manipulation by high-speed traders (WSJ, Sept. 17).

It appears that the regulatory HFT ball has finally started to roll. It took some time for regulators and investors to understand the role of HFTs after the Flash Crash of May 2010. The Flash Crash gave the market a $1 trillion shock, albeit briefly, and the first real inkling that HFT might need some better supervision. Regulators were unprepared for the responsibility, lacking the technology and Wall Street-style budgets to tackle the highly profitable and rapidly growing HFT business.

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That is changing. Part of SEC chairman Mary Jo White’s new 13-step program is to make HFT and off-exchange trading (dark pools) more transparent.

And, as regulators crack down on dark liquidity, HFTs are beginning to lose some of their most lucrative trading destinations. Dark pools account for some 17% of all trading on the $24 trillion US stock market.

As I said in July, dark pools appear to be allergic to the light that is being beamed into them. Barclays dark pool volumes plummeted after it was fingered by New York’s attorney general Eric T. Schneiderman in June for allowing predatory HFTs in. Shortly thereafter UBS, Credit Suisse, and Deutsche Bank were drawn into dark pool probes by regulators and authorities on both sides of the Atlantic.

As other global regulators join the New York AG, the predatory high-frequency trading sharks in dark pools appear to be heading for the exit. Liquidity is already suffering, and I predict there will soon be some major consolidation of dark pools. Many will simply close.

I expect the same is happening with HFT firms. Anecdotally, at least, there is evidence that HFT is no longer easy money. An article in Marketwatch.com points to high-frequency trading firm Virtu's bad fortune.

Not only did the firm ditch an IPO attempt soon after Michael Lewis's book, Flash Boys: A Wall Street Revolt, was released, but its CEO Vincent Viola is having a hard time unloading his flashy 19-room Upper East Side mansion. He has had to lower the listing price to $98 million from $114 million. It gives a whole new meaning to the word "haircut."

Dr. John Bates is a Member of the Group Executive Board and Chief Technology Officer at Software AG, responsible for Intelligent Business Operations and Big Data strategies. Until July 2013, John was Executive Vice President and Corporate Chief Technology Officer at Progress ... View Full Bio
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IvySchmerken
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IvySchmerken,
User Rank: Author
9/30/2014 | 10:17:12 PM
Re: playing catch up
There was talk of the SEC requiring HFT firms to register  and take on market making obligations, but so far nothing has happened. It remains to be seen what the regulations will be but the trend is toward more transparency and data reporting in general. This could be onerous for smaller automated trading shops, but I agree with you that larger players will stay the course.
Becca L
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Becca L,
User Rank: Author
9/30/2014 | 6:29:49 PM
Re: playing catch up
Good point, even if the HFTs take a hit, as surely the are, they have a big role in the current markets and, big-picture, likely aren't going anywhere soon. But I would agree many of the smaller firms are going to throw their hands up as the regulators get more demanding and the costs of competitive advantage get even higher. The big players with too much invested in colocation and direct data feeds will likely remain.
Becca L
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Becca L,
User Rank: Author
9/30/2014 | 6:26:33 PM
What goes around comes around
Ha, great article, Dr. Bates. September surely has been a rough month for HFTs, but as you point out it's been a long time coming. I enjoy the comparison to dark pools -  when all that is feared to be going on is revealed as true, the industry starts to pay for its boldness.

IvySchmerken
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IvySchmerken,
User Rank: Author
9/29/2014 | 7:46:06 PM
Re: playing catch up
There are many strategies that fall under HFT. Regulators may weed out  predatory strategies and some order types, but the overall style of automated tradng based on colocation and low latency doesn't seem to be going away anytime soon. Latency arbitrage has been deemed unfair, but if the SIP feed is altered to be based on direct data feeds, the speed advantages that HFT enjoys will be blunted. Like you said, these are firms that will migrate and adapt to other asset classes and regions. They are still the main liquidity providers in US stocks and futures, unless that changes.
NJ_trader
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NJ_trader,
User Rank: Moderator
9/29/2014 | 3:02:23 PM
playing catch up
the regulators will always be playing catch up with the FS industry. All players have too much invested to stand still and they will be constantly pushing the envelope.

The recent news you highlighted might slow down HFT for a while, but I have a feeling the players will move to another market, or focus their lightening fast technology on other, more lucrative, opportunities. 
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