High frequency trading is a form of automated trading that employs:
Algorithms for decision-making, order initiation, generation, routing, or execution, for each individual transaction without human direction;
Low-latency technology that is designed to minimize response times, including proximity and co-location services;
High speed connections to markets for order entry; and
High message rates (orders, quotes, or cancellations)
The wording is fairly neutral and to paraphrase the CFTC, emphasizes a mechanical description of activity.3 Casual conversations have downplayed its import, noting that there is no accompanying policy statement. This attitude is short-sighted.
The CFTC document notes specifically that the language is meant to have “a recognized legal interpretation” (emphasis in original document). The writers are looking forward to legally enforceable policies based on the definition. The CFTC goes on to note the definition’s importance in providing a basis for analysis by groups to include oversight and surveillance.4
The wording is to be used in context with the identification of abusive practices that should be prohibited; yet more policy in the works. There is implicit recognition that the first three points of the definition apply to virtually any broker in today’s environment by emphasizing that all four points must apply. This focuses policy attention on message rates, similar to discussions in Europe. Finally, the CFTC notes that a more narrow definition of HFT may lead to regulatory arbitrage, perhaps the clearest signal that the HFT badge is meant to silo the participants from a legal perspective.
For a participant, badges are targets. From a policy perspective, badges are constantly changing color and shape; worse, some participants wear more than one, often unofficially from the legal point of view. ITG’s recent discussion of the NYSE RLP initiative illustrates a new departure of exchange operations into areas (and policies) normally thought to be behind the badge labeled ‘broker.’ 5
The real issue in the preservation of market integrity and control of market abuse is behavior and as the bandit analogy suggests, behavior is not easily characterized by a badge.
A story may illustrate a general option. In a piece of popular fiction, the President of the United States asks an intelligence agent for a plan to eradicate the cocaine trade.6 Due to the classification of the drug as simply ‘dangerous,’ classic enforcement methods are inadequate because enforcement is restricted within the confines of the criminal justice system. The solution is to reclassify cocaine as a terrorist threat. This simple action permits a much wider range of enforcement options, as might be applied to chemical weapons. In the spirit of much fiction, the idea succeeds.
The practical version of this tale in financial markets is a reclassification of what constitutes market abuse in a computerized environment. The idea is not new. It is illustrated in a relatively new amendment of the U.S. Commodity Exchange Act.7 Certain disruptive activities, not previously classifiable as market or price manipulation, are specifically labeled as ‘unlawful’ and are subject to penalties. These include, for example, bids or offers with the intent to cancel the order prior to execution.
As of the end of February of this year, the NYSE and NYSE/ARCA filed proposed rule changes, adopting text from the Financial Industry Regulatory Authority, prohibiting the publication of manipulative or deceptive quotations or transactions.8
A start on such a reclassification also is made in the proposed EU Market Abuse Regulation, in which market manipulation is redefined beyond price manipulation.9 ESMA’s work provides another starting point, identifying computerized trading practices that reasonably fall into a definition of market abuse.10
A more general reclassification removes the need for precisely defining terms such as high-frequency trading or algorithmic trading. The suggestion pertains to behavior, regardless of the class of market participant. It is behavior that contributes to market integrity and investor protection, not the technology or the precise nature of trading strategies.
Technology and business strategy choices change continuously, while behavior leading to a stable market is easier to classify and is more stable in and of itself. The goal should be simple: identify bad behavior, write regulation to cover it and enforce the law, regardless of what badge is showing.
(This article originally appeared on ITG's The Blotter.)
1On the Road to Reg ATS: A Critical History of the Regulation of Automated Trading Systems, Ian Domowitz and Ruben Lee, International Finance 4, 2001.
2IOSCO, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency, Consultation Report, CR02/11, July 2011; presentation of the CFTC Technical Advisory Committee, at http://www. cftc.gov/ucm/groups/public/@newsroom/documents/file/wg1presentation062012.pdf
3The definition is a draft at the time of this writing, put together by the CFTC Technical Advisory Committee, Sub-Committee on Automated and High Frequency Trading, Working Group 1. It is not yet an official rule proposal from the regulator, and while a concept release on HFT may be in the works, it has not been officially introduced.
4Working Group 3 of the Sub-Committee on Automated and High Frequency Trading, CFTC Technical Advisory Committee.
5Keepin’ It Retail: SEC Approves NYSE’s RLP Proposal, Jamie Selway, July 11, 2012.
6Fredrick Forsyth, The Cobra, Bantam Books, 2010
7Section 747, amending Section 4c(a) of the Commodity Exchange Act (7 U.S.C. 6c(a))
8NYSE filing, Release No. 34-65954, file no. SR-NYSE-2011-61; NYSE/ARCA filing, Release No. 34-65955, file no. SR-NYSE/ARCA-2011-90.
9Proposal for a Regulation of the European Parliament and of the Council on Insider Dealing and Market Manipulation (market abuse), COM (2011) 651/3
10ESMA, Guidelines on Systems and Controls in a Highly Automated Trading Environment for Trading Platforms, Investment Firms, and Competent Authorities, Consultation Paper 2011/224, July 2011pp. 26-27