From The Market Ticker
Lauren once again has an insightful interview, this time with Nanex’s founder.
But the entire high-frequency trading space isn’t anything new, really. Back before the Tech Bubble really took off I did some work for a shop that was involved in the HFT of the day, arbitraging currency markets between venues across the Atlantic.
Arbitrage, incidentally, isn’t bad — it’s necessary. It is what makes a cohesive market possible; without it market diverge on their own. But with it when prices diverge across markets someone buys in the cheaper market and sells in the more-expensive. This is what brings markets back into balance between venues.
The problem with HFT as defined today is that it is simply a game to circumvent both The Securities Act and the alleged requirements of Reg-NMS.
NMS says that best bid and offer must be advertised and enforced. It attempted to put a stop to privileged pricing that was exploited by those with “better access” to the disadvantage of the common investor. The Securities Act, for its part, makes unlawful any device or act intended to manipulate price, whether an actual execution takes place or not (that is, if you try to manipulate a market by putting forward the appearance of trading, or intent to trade, when no such intent exists you’re breaking the law.)
I think the solution to the problem of HFT is quite simple, really and have written about it on multiple occasions. Impose a 2-second quote life rule (or until executed) and at the same time mandate that every order you have outstanding be backed by margin capacity to clear. This instantly stops the games since now every order must be exposed to the risk of execution by anyone in the market and in addition you can’t place any order that you cannot clear.
Retail traders already live with the latter restriction; the brokerage systems we interact with will not permit us to submit an order that violates our margin capacity. But this clearly does not appear to apply to the HFT “boys and girls”, who submit literal millions of quotes and almost-certainly cannot clear those trades against the exchange’s margin limits, were they all to execute.
The entire purpose of regulating a market is to provide some assurance that it actually is a market. It is only through being reasonably-certain that when you pull into a gas station and pump 10 gallons of gasoline that an actual 10 gallons will be dispensed that confidence in the fuel distribution system is obtained by the common man. The original fuel pumps had large graduated glass globes on top into which fuel was pumped and then dispensed under gravity feed.
This allowed the customer to see that when he bought 5 or 10 gallons of gasoline he actually got 5 or 10 gallons and not some lesser amount, and that the “gasoline” he was sold was not half water. The dawn of certification laws, sealed pump mechanisms and inspections that continue to this day made the glass globe on the top of the pump unnecessary and they disappeared, but the underlying principle remains — fairness in commerce.
HFT has two purposes, one legitimate and one not. The legitimate purpose is to arbitrage disparate markets and thus bring them in line with one another. I have no quarrel there.
But the illegitimate purpose is to try to find ways to obscure that sight glass on top of the pump so that the common man cannot see what he is buying or selling and thus is disadvantaged.
Not only is such a practice wrong, it’s illegal — and until it is stopped we will not have a balanced market, nor will confidence in the market return.