Trading Technology

01:05 PM
Behzad Gohari
Behzad Gohari
Commentary
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Mind the Gap Between Regulation & Innovation

The real reason HFT is under the spotlight isn't the frequency of the trades. It's the gap between regulation and innovation.

High-frequency trading (HFT) -- placing a multitude of orders per second -- has garnered renewed attention since the release of Michael Lewis's latest book, Flash Boys. The controversy surrounds the ability of some market players to see and pre-empt large institutional orders and -- because of their technological proximity to the exchange -- and earn a profit as a result of their access and speed.

Front running, where a broker executes a trade before a client for personal gain, is banned by FINRA Rule 5270. This rule is a broader, more comprehensive ban than the one put in place by the NASD, yet it does not cover the practice of some high-frequency traders. One would think that an easy fix would be to extend that ban to HFT. So why all the noise over HFT?

High-frequency trading is just a term. It's the equivalent of calling a Ferrari a high-speed horseless buggy. However, in the discussion of HFT, it is often the speed (high) and/or the number of trades (frequency) that bears the blame, not the people who conduct them or design the computer programs that do so. In essence, many blame the technology. This is an old problem that began in literature decades ago, moved into the theaters, and is now an accepted axiom of our popular culture: Machine bad, man good.

[To read more about what people are saying about high-frequency trading and how it should or should not be further regulated, read: Reframing the HFT Debate.]

From Hal, the fictitious computer in 2001: A Space Odyssey, to Skynet, the computer system in the Terminator movies, popular culture has made it easy to blame technology. Moreover, machines, unlike in the movies, do not show up on CNBC to defend themselves. Vague terms like HFT give credence and weight to the criticism of technology. Therein lies the problem. HFT has been around long enough that anyone with even a shallow knowledge of the technology, as well as a basic understanding of the securities laws of the United States, can separate fact from fiction.

It is a fact that the US securities laws, though amended over time, were designed for a disclosure-based system that came into existence in an era with the technological equivalent of can-and-string communication. Furthermore, the rule-making process favors those with the knowledge and resources to respond with public comment and thus have a larger say in the process. This practice and its practitioners, though well intentioned, move forward slowly and narrowly. As a result, regulation often lags behind technological innovation. The budget and staff of the agencies responsible for regulating the markets pale in comparison to the vast sums invested in the technology infrastructure of the markets. This exacerbates the gap between regulation and technological innovation.

The financial services industry is built on a business model wherein one of the primary sources of revenue is intermediation. Oddly, technology has squeezed both the revenue and the margin available. Why is it a surprise that firms would seek a competitive advantage by attempting to gain a technological edge? If regulation is silent on the matter, then why is it surprising when certain actors enter the market with the intention of gain through regulatory arbitrage?

If the regulatory process -- by its nature and resources -- is slow, and technological innovation is fast, the ensuing gap will always exist. The solution is not to blame the technology, prohibit innovation, or press for more narrowly tailored regulation. Instead, there can be a set of principle-based rules that address the specific gap between regulation and innovation and prevent some from utilizing new technology to achieve an undesired outcome.

The problem with such a regulatory approach is that it does not blend well with our current system of rules and disclosures. In such a system, the actors rely on rules that are broad enough to achieve the narrowly tailored regulatory goals set before them. If the rules are too broad, they risk a backlash in the courts. If they are too narrow, they fail to achieve their intended outcome.

There is hope that the desire for bringing balance to the markets over the long term will outweigh the desire of the parties simply to fix the problem at hand. In the end, the controversial use of HFT is only the latest manifestation of the problem. The real problem has been, remains, and shall always be the gap between technological innovation and regulation. Without broad principle-based rules, that gap will continue to leave an opportunity for some actors to profit through their technological ingenuity, at the expense of the players without access to such technology in the market.

Behzad Gohari is a Managing Director at The Althing Group, an advisory firm helping clients navigate the capital markets. Over two decades, and through a dozen startups, he has acted as founder, investor, and strategic advisor, as well as utilizing his ... View Full Bio
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Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
7/3/2014 | 12:28:03 PM
Re: This would be a big shift
For example, right now the rules allow for market participants to take advantage of speed differences created by advanced technology. Exploiting those speed differences, which includes stepping in front of orders detected on another exchange, is perfectly legal. Essentially, the rules allow for electronic front running. Under principle-based rulemaking, if done correctly, the rules wouldn't have to specifically address each new advantage created by technology.

IvySchmerken
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IvySchmerken,
User Rank: Author
7/3/2014 | 10:33:57 AM
Re: This would be a big shift
Latency arbitrage is enabled by the proliferation of multiple exchanges and dark pools and the varying speeds of direct data feeds vs. the SIP. How would principle-based regulation eliminate latency aribtrage?

 
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
7/3/2014 | 7:47:07 AM
This would be a big shift
Moving to principle-based rules requires the regulators to completely change the way they monitor financial firms (in the US). The regulators in the US differ from the EU, which often provide principle-based regulation. Principle-based rules, especially around HFT, would eliminate some of the problems that have been created around latency arbitrage.
IvySchmerken
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IvySchmerken,
User Rank: Author
7/2/2014 | 3:32:52 PM
The reactionary regulatory process
Behzad, Thank you for your insightful article. You raise some important points about how regulators are always chasing the most recent innovation. In this case, that innovation is high frequency trading. As we know, regulators are examinng the laws that led to this type of trading. Reg NMS spelled out some very specific requirements, such as the trade-through rule. If regulators decide to abolish or tweak any of these rules, it seems like you are suggesting a more principle-based style of regulation. I think you are saying that automated traders innovated to overcome speciific rules. How would equity trading be different if the SEC implemented principle-based guidelines? Would the gap between technology and innovation narrow?
KBurger
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KBurger,
User Rank: Author
7/2/2014 | 1:03:25 PM
Not more or less, but different
Thanks for this very interesting and thought-provoking analysis. Your points make a lot of sense. Another way of looking at this -- when it comes to regulation, it seems like the discussion boils down to "Less or More." That is, the discussions and debates are all about adding more rules and requirements, or reducing eliminating the -- NOT about what kinds of new or changed type of regulation there needs to be to respond to innovation (which is largely, but not exclusively, tech-driven -- it could be product or marketing innovation, too) and market developments. Once there's a shared understanding about the regulatory and competitive issues around something new, then (ideally) there can be a serious discussion about what to eliminate. Unfortunately, in the current political, media and business climate, there doesn't seem to be any acknowledgement of nuance or that things are not just black/white, good/bad, etc.
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