The Securities and Exchange Commission appears to be covering several critical bases when they unveiled plans today to reign in high frequency trading (HFT).
Wide ranging proposal touching in some sensitive spots
Speaking to a Sandler O’Neil conference in New York, White hit all the cords saying for the first time that payment for order flow is under review for regulatory action. In the speech White hit on key points, such as conditional order types, market maker expectations and dark pool transparency.
“The markets are not rigged,” she proudly proclaimed to CNBC’s Bob Pasani as she exited the speaking podium. “We have the strongest, most resilient markets in the world. It doesn’t mean they are perfect,” she said, noting market structure is always under review. “Investors are much better off today than 20 or 30 years ago,” she quipped upon leaving, an apparent reference to the lowest transactions costs in the history of investing.
Highest level of flash crashes does coincide with lowest transaction costs in history
She forgot to mention, however, it is also the highest level of flash crashes in history. This is the big issue, yet to be fully explored in public. Flash crashes are mechanical in nature and the HFT firms and market makers all know how the market making software works. When White said they were going to watch for “disruptive market behavior,” what she could be referring to is tracking individual HFT firms who may be aware of the limits of market liquidity and then are said to know how to push market prices at will. This is the real issue, the hole in market structure that HFT has been exploiting since the flash crash of 2010.
Based on analysis of her speech, White might be considering individual registration of HFT participants and then tracking of their trading to detect market abnormalities or abuses. Such tracking is currently being done at the exchange and brokerage firm level, with all trades already linked to a trader at the brokerage level. What White might do is connect dots between information already being collected at the brokerage and exchange level on trade responsibility and tie that into their tracking. That way, when a flash crash does occur the SEC could use this knowledge to identify potential market manipulation.
Manipulating markets is a mathematical game – HFT
Manipulating markets is a mathematical game and each market – from commodities to indicies to much less liquid individual stocks – all have volume limits. Once this limit is breached the market moves in that direction. Professional traders are all aware of these levels. When an individual trader breaches this level market manipulation can occur.
On a slightly more humorous but equally important note, White discussed algorithm testing. This should be an obvious procedure in all HFT firms, but apparently not. Knight Capital lost over $400 million in less than one hour with an algo gone wild. The market making software was said to be buying on the offer (the higher sell price) and selling on the bid (the lower buy price) on the bid ask spread. Said another way, they were selling low and buying high. This went on for one hour before a human caught the problem.
Another issue White addressed were conditional orders, which can display inaccurate prices, and the vast number of order types that are customized for each HFT firm. This is like going into a Chinese restaurant, ripping up the menu and ordering fried chicken. It can be done but the result isn’t going to benefit anyone other than the HFT firm. In fact, the preponderance of order types has come under sharp focus from former CFTC Commissioner Bart Chilton, who called into question HFT tactics that could endanger market stability.
White appears to be taking solid aim at what some call the cess pool: non-transparent trading venues called dark pools. This is where those running the trading venue can make up the rules and not publish them to participants. This, along with lightly if ever disclosed payment for order flow deals, may appear to be a conflict of interest.
Today White looked like she his was firing on all cylinders. Now let’s see if they execute on the grand vision.