Head-to-head: does US HFT need stricter oversight?

Author: | Published: 27 Aug 2013
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The crux of this question is whether there is anything new or particular to high-frequency trading (HFT) that demands special regulatory attention. Definitions of HFT vary, and the label is imprecise as it groups together a variety of distinct practices and tactics that may affect markets in different ways. Nevertheless, all agree that HFT is characterised by extremely high speed, and autonomous operation. Both of these properties can cause markets to perform in modes not possible before the advent of HFT, and we have substantial evidence of anomalies caused by HFT activity. So what is it that makes HFT qualitatively different, such that it needs regulatory scrutiny?


First, the very speed at which HFT operates introduces qualitatively new patterns of activity. High-frequency traders receive and process information from exchanges with ultra-low latency measured in milliseconds, and are able to react with orders within a few milliseconds more. Such speed provides an edge in responding to economic news, which translates to profitable advantage as the first responder reaps the benefit of executing against mispriced outstanding orders.

"We have substantial evidence of anomalies caused by HFT activity"

Most of the time, however, there is little substantial news – in the majority of milliseconds, nothing of real-world economic consequence actually happens. As such, the advantage is actually deployed in response to events within the market itself.

Momentary mispricing arises even in the absence of news, simply due to the short-term imbalances of supply and demand induced by order flow. The winner-takes-all nature of response to mispricing leads inevitably to a latency arms race.

This sees competing high-frequency traders take extraordinary measures involving enormous investments in technology and communications infrastructure to shave microseconds off their response time and thereby improve their odds of winning the profit opportunities that arise throughout the trading day.


Second, the autonomy of HFT increases the difficulty of anticipating its effects in complex or unusual situations. Autonomous operation is of course necessary to compete in the latency arms race, and the ability to process high volumes of information at great speed is a great spur to automation.

Human traders may likewise be unpredictable, but we have hundreds of years of experience with them, and the relative slowness of human-scale trading can limit damage accrued before measures are taken.

New behaviours

That HFT may introduce different behaviours to the market is not in itself a bad thing. Indeed, the general progress in automation of trading is quite likely responsible for reductions in transaction costs and improvement in price discovery. What the point about qualitative differences does entail a priori is that HFT deserves special scrutiny in case such extremes of speed and autonomy contribute to systemic risks, or allow particular trading tactics that detract from efficiency or otherwise degrade the performance of financial markets.

The a priori argument is only strengthened by evidence from experience. The most notorious market HFT anomaly to date was the so-called Flash Crash of May 2010. Whereas some consider HFT to have been exonerated as the proximal cause of that incident, many knowledgeable observers argue that the predominance of HFT actors in the affected markets enabled the subsequent response, by suddenly withdrawing the liquidity they had generally been providing. And although the Flash Crash left no permanent damage and has not been repeated, as far as we understand it could happen again at any time. In fact, it has been reported that so-called mini flash crashes in individual securities have actually been occurring with some regularity in recent months.

Flash crashes

The question of flash crashes underscores how little we actually understand about the implications of pervasive HFT activity. Numerous academic studies on HFT in the last few years – based on theoretical models, or empirical data analysis – have shed light on aspects of HFT. But the overall picture remains incomplete at best.

Standard theoretical finance models, generally speaking, abridge the fine granularity of information transmission time scales driving the latency arms race. And even the most thorough data analyses have difficulty identifying the effects of particular HFT strategies. What we care most about – the potential exacerbation of rare and extreme market events – is inherently difficult to study.

This is because, by definition, the conditions present themselves only rarely.

All this suggests a need for more fundamental research for the long-term, and continued vigilance in the short-term. Prudence in the face of uncertainty calls for regulatory scrutiny, but also dictates a posture of humility and cautiousness in promulgating specific measures.

The most effective lever

The proper goal of regulatory oversight is not to diminish automated trading per se, but rather to promote the beneficial HFT tactics and discourage the practices deemed malign.

Prohibiting the perceived harmful tactics directly is often difficult to enforce, given that trading strategies are generally unobservable.

In many cases, the most effective lever is the design of market rules that align incentives, by rendering the discouraged strategies more costly or less effective.

By Michael P Wellman, professor of computer science and engineering at the University of Michigan


Middlemen have never been popular. Something just feels wrong about paying someone to be introduced to a counterparty you could theoretically find on your own. Monopolies have never been popular, either, especially cartels conspiring to jack up prices. So what should we think about cartels of middlemen creating monopolies to jack up prices?

We start this argument against regulating HFT with this question in the hopes that, when we come back to it later, it will help us better understand why we're in today's dilemma. And we are in a dilemma. Every retail investor you ask will tell you that the market is rigged by HFTs, whose speed, collocation, algorithms, and automated cancellation of thousands of what are deemed phony orders are causing a gaping lack of confidence in the Securities and Exchange Commission's (SEC) all-electronic National Market System (NMS).

But if you run the actual numbers, trading has never been cheaper or easier for the retail investor. The amount high-frequency trader's earn, even in good times averaging only a tenth of a cent per share, is dropping like a stone as more competitors enter the business. The sector earned $1.25 billion in 2012, down three quarters since 2009. No conspiring cartels jacking up prices here. So why do investors hate the traders providing this unprecedented cost-reduction benefit?

"If you run the actual numbers, trading has never been cheaper or easier for the retail investor"

The answer, ironically, may lie in the very success of NMS at reducing costs. HFT is the apotheosis of the SEC's decades-long crusade to apply fairness to the market by forcibly automating the old human trading processes. The problem is, once you get onto the fairness treadmill, the demands for more fairness will never cease. As it asymptotically approaches the perfection of middleman-free trading, the SEC will always hear gripes about the advantages middlemen still have, which will never seem anything but unfair and unjustified.

In this atmosphere there are no cures for HFT that can make a positive difference in the way it is perceived. Not assessing cancellation fees, or requiring a minimum time on the book before cancellation, or imposing market making obligations. None of these will make any difference in the perceived unfairness of HFT, and all would be uselessly disruptive as the markets once again have to deal with major structural change.

Moreover, none of these reforms would address the real problem this obsession with fairness has caused. Namely, that the capital pipeline of new initial public offerings (IPOs) has virtually dried up as the human middlemen who once made raising capital their mission in life were wiped off the board by NMS. There may be some way to raise capital on level playing fields, but no one has found it yet, including the SEC.

So, again, what should we think about cartels of middlemen creating monopolies to jack up prices? Back in 1792, when what became the NYSE was taking shape as a price fixing cartel called the Buttonwood Agreement, the main thing the public wanted was not to prevent the conspiring, but to get a piece of the action. The newly free and ambitious Americans just wanted in on the speculative opportunities the Buttonwood brokers were offering. After all, 1792 was only 16 years after the Declaration of Independence established the right to be, among other things, greedy middlemen or speculators.

'Speculation is the essential native genius of Wall Street,' according to one historian and former SEC director of the Office of Policy Research writing years later about the Buttonwood period, (Walter Werner, Wall Street, 1991). Why did we ever think creating the SEC to rein in speculation was a good idea? Sure, there was the crash of 1929 and the depression. But that might just prove the old adage: act in haste, repent in leisure. In any case, why do we still think today that letting the Commission destroy the structure of Wall Street by imposing fairness will improve its functions?

The essence of Buttonwood was the unfair separation of members from non-members, as the insiders pledged to maintain that separation and to help each other exploit its advantages. Back then, getting ahead was not a crime. The last thing we should be worrying about now is leveling the playing field between HFTs and regular investors. Focusing on this mission impossible is only giving the SEC further licence to expand its capital-destruction agenda. Better to just enjoy the nearly-free trading provided by HFT, and worry about how to get the SEC and other regulators out of the way of raising capital before the economies of the west drop further into their economic sinkholes.

By Steve Wunsch, a New York-based writer and market structure consultant. His latest book, Nature's God, is available as a paperback or Kindle e-book.