Market Structure Series (Part II): Addressing High Frequency Trading

Addressing High Frequency Trading and Promoting Fairness

While Chair White dedicated little of her speech directly to the promotion of fairness in the markets, it is important to keep in mind that every action Chair White outlined in her remarks is proposed with that as the intended goal. Fairness has been a core issue of public debate when looking at the impact of speed on the markets. High frequency trading-led electronic markets have played an important role in democratizing the marketplace, making access more fair and open than the antiquated models of floor trading.

Chair White outlined some foundational points on HFT, its role in the market, and how she views change that help to frame the context of her remarks:

• HFT is a sub-class of algorithmic trading, as is a large percentage of institutional trading, and algorithmic trading likely is over half the trading volume;
• “Many brokers use the same tools on behalf of their customers”; and
• “SEC should not roll back the technology clock or prohibit algorithmic trading” but rather should assess the extent “specific elements of the computer-driven trading environment” are working in opposition to investors.

With these points laid out, Chair White when on to address two primary areas of concern:

• “Aggressive, destabilizing trading strategies in vulnerable market conditions, when they could most seriously exacerbate price volatility”; and
• Ensuring a level playing field and fairness to investors.

Disruptive Trading

Aggressive, destabilizing trades are already somewhat controlled by volatility moderators that are already implemented in the market, such as limit up / limit down and market-wide circuit breakers. However, Chair White explains we should look for further protections, asking the SEC staff to develop a recommendation for an anti-disruptive trading rule, which:

“…will need to be carefully tailored to apply to active proprietary traders in short time periods when liquidity is most vulnerable and the rise of price disruption caused by aggressive short-term trading strategies is highest…”

Disruptive trading hurts all market participants and Chair White will undoubtedly find that the majority of market participants are aligned in wanting to remove it from our markets.

Purposefully disruptive trading is akin to market manipulation, against which many rules and precedents have been set. While strengthening rules against wrong doers should be applauded, we must ensure that the creation of new rules does not distract from or further complicate enforcement of the rules that are already on the books. As is often the case, better enforcement of already established rules would go a long way towards solving many of the existing challenges.

The SEC’s ongoing data-driven approach to regulation should continue as it relates to disruptive trading. If additional rules are necessary, we must first quantify disruptive trading. Types of disruptive trading should be well defined and instances should be identified in market data. No matter how well-defined; there will be false positives. Care should be taken to fully explore all instances, weed out false positives, and use them to improve detection.

Finally, we must ask if this rule does enough? Chair White limited the rule by saying it must be “tailored to apply to active proprietary traders in short time periods.” Why only look at active proprietary traders? Why only short time periods? Disruptive trading is disruptive trading just as manipulation is manipulation. A rule around disruptive trading should apply to all market participants, no matter their speed, no matter the time period, and no matter the type of trader.

Fairness for Investors

Chair White used her speech to address a common question of the general public: are low latency tools fair to investors? Even in asking the question Chair White pointed out that these same low -latency tools are available to investors through brokers, which goes a long way to show that the playing field is indeed level.

One aspect of the market often questioned is the latency difference between direct feeds and the SIP. This is clearly a fairness issue, but it is important to remember that this is not an HFT issue. Rather, this is an issue that resides at the exchanges. Chair White proposed three efforts to improve fairness around the SIP and direct market feeds:

• Exchanges should distribute data to direct feeds and the SIP equally;
• Exchanges should disclose how and for what purpose they use different data feeds; and
• Timestamps should be included in consolidated feeds so that market participants can better understand SIP latency.

While these proposals would do a great deal to improve transparency in the market, benefitting all investors, these recommendations alone will not make the SIP equal in speed.

Additionally, exchanges and FINRA should provide data at the same speeds to the SIP as they do to their direct feeds. However, the way the SIP currently works, all data has to travel to an aggregator and is slowed down by the aggregator which is at a severe technical deficit. The SIP needs to be drastically improved and the entire model rethought, for the SIP to rival direct feeds.

Market-Driven Solutions

Chair White’s final remarks on HFT and fairness in the markets are encouraging to hear. She is open to and encourages market-driven solutions to issues and changes to market structure in order to continue ensuring that investors have safe, healthy, and efficient markets. Chair White is:

“Wary of prescriptive regulation that attempts to identify an optimal trading speed, but I am receptive to more flexible, competitive solutions that could be adopted by trading venues.”

In order to encourage such innovation, she is open to considering changing SEC rules and market practices that do not incentivize innovation, but rather stand in the way of exchanges experimenting with such changes.

As we continue to ensure ongoing fairness for all investors, it is important to take the principles-based approach that SEC Chair Mary Jo White advocates. Rather than turning back the clock, we should embrace the benefits technology, automation, and innovation have brought to today’s modern markets and leverage them further to continue improving market quality.