On 28 September outgoing US senator Ted Kaufman of Delaware made his final remarks to the senate floor. Referring to the capital markets, he noted that “the most striking change has been the rise in high-frequency trading (HFT), which has come to dominate the equity markets”. Kaufman, who has a background in engineering, wasn't taking a neo-Luddite stance against the machine, but rather he was urging caution over the dangers of automation.
The ”flash crash' on 6 May 2010 saw a sudden fall of 1,000 points in the Dow Jones Industrial Average between 14.40 and 15.00 EST before a similarly sharp rebound. At points during that period, the shares of large companies such as consulting and services firm Accenture were trading at $0.01 cents. Many initially blamed HFT, but a report published on 1 October by US regulatory authorities the Securities and Exchanges Commission (SEC) and the Commodity Futures Trading Commission (CFTC) has established that the events of 6 May were triggered by algorithmic trading, not HFT.
HFT covers a multitude of different trading styles but at its core describes strategies that disseminate a high volume of trading signals designed to exploit tiny price differences using technology that can rapidly process market data. Firms that employ these strategies operate on thin margins and therefore trade in large volumes to turn a decent profit.
HFT firms typically need to be able to cancel orders quickly and replace them with new orders in case the price moves against them, which results in a huge amount of orders being placed and cancelled. In his testimony to a joint CFTC-SEC committee, Kevin Cronin, global head of equity trading at asset management firm Invesco, pointed out that some market sources put HFT order cancel rates at 95%.
HFT also takes trade automation way beyond other market participants. Because speed is essential to the success of many strategies, automation of the order trigger, not just the execution, and elimination of latency are pre-requisites. Algorithms are therefore crucial for HFT. But errors cannot be eliminated and when they occur at such speeds and volumes, they can cause disruption on a massive scale.
For now the dangers are apparently only theoretical. Where markets have been disrupted by technology-led trading, such as on 6 May, HFT has not been the cause. However regulators, burnt by the multitude of crashes, scares and scandals that have plagued markets in recent years, are not in the mood to let innovation take precedence over safety.
The SEC has demonstrated its stance with proposals to ban both naked direct market access, based on the model's lack of pre-trade risk management, and flash orders, which are seen as potentially creating a two-tier market. Other proposals such as the large trader reporting system and consolidated audit trail have been suggested in part to enhance the post-trade analysis process for regulators in the event of a market incident. These proposals are still currently outstanding despite being over a year old in the case of the flash order ban.
It is likely then that HFT firms will see some restrictions imposed upon them by ultra-cautious regulators. Pre-trade risk management could prevent algorithms acting erroneously. Limits on cancelled orders could reduce HFT activity. Increased trade reporting would at least give regulators a clearer picture of events for analysis.
Kaufman noted that SEC chairman Mary Schapiro had written to him a year ago asserting “If … the interests of long-term investors and professional traders conflict … the Commission's focus must be on the protection of long-term investors.” As HFT is all about professional execution and has very little to do with long-term investment, practitioners have every reason to expect continued attention from regulators and legislators.
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