As high-frequency trading (HFT) moves into the government’s crosshairs, with concerns speedy traders are accessing markets with undue advantage, Goldman Sachs Group Inc (NYSE:GS) Chief Operating Gary Cohen weighs in with an editorial in the Wall Street Journal – and he surprisingly touches on some rather sensitive topics.
Cohen begins his ‘opiniontorial’ by lauding today’s markets “narrower spreads, faster execution and lower overall explicit costs to trading stocks.” It should be noted that these issues have been cited by market makers to have led to the profit compression in the business of providing two-sided markets utilizing a non-directional market strategy. In a search for profit, certain market makers were pushed by narrowing spreads into HFT strategies based on successful bets in market direction.
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Hitting on a key issue, he notes that as the “overwhelming majority of transactions now done over multiple electronic markets each with its own rule books, the equity-market structure is increasingly fragmented and complex.” Without touching the third rail term “dark pools,” Cohen deftly refers to the controversial trading venues when he notes there are 13 public and 50 “alternative trading systems,” then launches into Regulation NMS which requires brokerage firms to route orders to the best price, a hot dark pool topic of late.
Cohen transitions from one hot topic to the next as he discusses the fact that “multiple technology failures have occurred in the equities markets, with a severe impact on the markets’ ability to operate.” Exchanges have increasingly faced technical challenges in 2013, some of which were said to emanate from foreign countries. Although he notes progress, he delivers a zing and points to a solution, saying “there has not been enough progress. Execution venues are decentralized and unable to agree on common rules.” Then he points to the need for regulator involvement. “While an industry-based solution is preferable, some issues cannot be addressed by market forces alone and require a regulatory response. Innovation is critical to a healthy and competitive market structure, but not at the cost of introducing substantial risk.”
Cohen then provides four recommendations.
The first seeks to address the frequency of market disruptions, proposing that “all exchanges adopt a stringent set of uniform, SEC-mandated execution controls.” Hitting on a potential solution for a major high frequency trading problem, he recommends “limit-up, limit-down rules that prevent trades from occurring outside a specified price band, pre-trade price and volume limits should be implemented to block problematic orders from entering the market.” These were all issues in the 2010 flash crash, as this proposal addresses key concerns of market watchers.
Is Cohen calling for a different exchange financial model?
His second proposal is nuanced, calling on incentives to “reduce excessive market instability,” Cohen seems to request a different revenue model for exchanges other than trade volume. Trade volume and the revenue it generates are key reasons why the exchanges have been so staunchly in the corner of high frequency trading. This is a fascinating and fresh tact, but he failed to spell it out in detail. Then Cohen mentions some of the key strategies certain HFT firms are known to use to game the electronic market making software: “Transaction messages direct the placement, cancellation and correction of orders, and in recent years they have skyrocketed,” he wrote. “In the 2010 “flash crash,” a spike in the volume of these messages exacerbated volatility, overwhelming the market’s infrastructure.” In order to reduce the message flow, Cohen radically proposes a regulatory “tax” on such messages. The regulatory fee proposal has been implemented in Canada and Australia, he noted.
Equal treatment of market data
Once again touching a controversial topic, Cohen calls for a third solution. “Public market data should be disseminated to all market participants simultaneously. Exchanges currently disseminate prices and transaction data to the SEC-sanctioned distributor for all investors, but exchanges may also send this information directly to private subscribers.” Firms such as Business Wire and others have recently discontinued the practice of providing a system that enables HFT firms to trade on market data quicker than the average public. Cohen is illuminating a little discussed topic of exchanges discontinuing the practice of providing similar benefits to HFT firms. “Removing the possibility of differentiated channels for market data also reduces incentives that favor investment in the speed of one channel over the stability and resiliency of another,” he writes.
His fourth proposal is to give clearing members better real time risk management tools, clearly a sleeper compared to the politically charged topics he previously raised.
Cohen does a masterful job of speaking to two audiences. The article has enough “happy talk” gloss for general investors to think the stock market structure is stronger than ever. Sophisticated participants will identify the significant issues raised and the direction in which he is pointing the industry.