HFT: Speed Isn’t the Problem

There is going to be a hearing on HFT in the Senate.  Senator Jack Reed of Rhode Island (D) will preside.  I have met Jack a number of times and my gut tells me he will run a pretty evenly balanced shop.  I don’t think he has a dog in this fight.

Most of the debate is probably going to center on speed.  Speed is not the problem with high frequency trading. Speed is actually better for markets because information is transmitted faster allowing supply and demand to re-align more efficiently.

The regulators (SEC, CFTC) and exchanges ($NDAQ, $NYX, $ICE, $CME, $CBOE) have created an artificial tiered system of distribution.  Co-location has allowed certain firms to utilize their speed advantage by being closer to the order flow.  It’s not any different than the fat cat local that stood next to the right order filler in the pit.  They saw and heard flow before anyone else.  No surprise they made the most money.

In pit trading, there were a fixed number of order types.  Market, Limit, Stop, Fill or Kill, or Broker’s Discretion (DRT).  There was some flexibility with One order cancels the Other (OCO),  Market on Close, or Stop Close Only restrictions-but the same basic order types ruled the day.  Humans made sense of it all and maintained an orderly market.

The problem with face to face human trading as the world expanded wasn’t the humans or the lack of innovation, it was access.  Electronic trading allowed access to greater numbers of traders and leveled playing fields.  It should increase competition.  Instead, competition has been decreased.  Part of this is due to federal regulations, and part due to exchange policies as well. No surprise, the HFT traders with the best location are making all the money.

What we see today is a smaller and smaller group of traders pushing more and more of the volume.  There is more total volume, but the breadth of that volume is smaller.  Markets work best when there are infinite numbers of participants competing in one place to discover the best price.  That’s not what we have in electronic marketplaces today.

If you want to see a symptom of the lack of breadth, check out membership prices at exchanges.  If breadth were accelerating and increasing, along with increasing volumes-membership prices would be on the upswing. Owning or leasing a membership allows a trader to save thousands to millions on trading commissions depending on their volume.  Instead, what is happening is membership values are cratering, and lease values are depressed.

Part of the decreased value of membership is the stain Jon Corzine and MF Global put on the industry.  Another piece of the downturn in prices is the Federal Reserve policy of QE forever.  However, if electronic trading were increasing the amount of participants, demand should be increasing, not decreasing and that is not the case.

Instead of focusing on speed, we need to focus on level playing fields.  Eliminate tiered systems and force market participants to interact with each other in one centralized place.  Compete on wits, knowledge, probability theory, charts, or risk assumption-but make it on something other than regulatory or physical location arbitrage.  Because that is the situation today-and long term it hurts the marketplace.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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