Moves to regulate high-frequency trading (HFT) firms need to refocus on their responsibilities as market makers, according to David Weiss, senior analyst at consultancy Aite Group.
Concern over the impact of HFT on financial markets has intensified in recent weeks, culminating in the publication of a new book on the subject by broker-turned-author Michael Lewis, ‘Flash Boys’.
Aside from the pre-launch publicity, regulators in multiple jurisdictions have taken steps to control HFT. Germany introduced an ‘algo-flagging’ rule yesterday as part of its HFT Act, the first piece of legislation by a European country to specifically target the practice, while the New York Attorney General last month announcing an investigation into the “unfair” advantages employed by HFT firms.
However, Weiss said that much of the focus by regulators so far has been on limiting the technology used by HFT firms, such as co-location facilities, low-latency data and proprietary algorithms, despite these tools being commonly used by a range of market participants.
“The reaction by regulators has come far too late and the damage has already been done from a technology perspective,” he said. “Today, algos are used by everyone and are vital for a pension fund to sell a large block of shares. Regulators have also talked about banning co-location, but these days the companies that own the data centres fall outside of their reach.”
Weiss said regulators should instead consider imposing new liquidity obligations on HFT firms that act as electronic market makers.
“At the moment, high-frequency traders operate as quasi-market makers. They have the rights of market makers but none of the responsibilities and tend to withdraw their liquidity from the market rapidly when it is most needed,” he explained.
Some buy-siders have welcomed the provision of liquidity by HFT firms, but remain concerned about their ability to rapidly cancel orders, causing liquidity to dry up. Weiss believes tackling this inconsistency would help stabilise markets.
So far, only European regulators have recognised the need for tighter controls over HFT’s role in market making, with MiFID II proposing rules to force market makers to maintain liquidity levels on the markets they trade in.
MiF`D II also proposes controls on trading algorithms and other technology that is today used by a wide range of market participants. John Adam, head of product management at market technology provider Portware, said this type of technology has become so ubiquitous that most market participants do not see it as a major problem.
“Among our buy-side clients there is an acknowledgement that HFT is a reality in the market today and can yield benefits if you’re able to interact with it efficiently,” he said. “Firms have already taken steps to ensure their infrastructure and tools are able to trade with or against HFT.”
Weiss said US regulator the Securities and Exchange Commission (SEC) should have paid more attention to HFT firms’ technology superiority when HFT firms were taking advantage of the financial crisis and eroding investor confidence.
“The SEC was off the ball when HFT first came around and now the average retail investor in the US thinks the market is rigged against them. They’re too late to do anything about the technology and this is why they should change their focus.”
In March, the SEC said it was looking into possible abuses by high-frequency trading firms using dark pools, in a joint investigation with the FBI, with a focus on layering of orders and news aggregation algorithms. It has also begun work on formally defining and characterising HFT with a view to further regulation, but this work is in its early stages.
Lewis’ book has stirred up considerable reaction from the industry. Its main criticism is that the techniques employed by HFT, and exchanges’ reliance on HFT business to support their revenues, essentially mean the stock market is rigged against the interests of both retail and institutional investors. Not only is it sapping confidence in the stock market, said Lewis, but is also damaging to the returns of pension funds that normal people are relying on for their retirement, while making a select few very wealthy.
High-frequency traders and exchanges have hit back, saying the market is not rigged and the opinions expressed in Lewis’ book are not grounded in fact, but based on opinion. Nonetheless, the controversy surrounding HFT is set to continue.