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26 September 2012

We Need Leadership

Many of the articles and comments on this forum are directly related to HFT, either espousing the benefits, or warning of the dangers of this contentious practice. But there has been one voice that has been sorely missing from this debate, and it is that of the SEC.

The debate over High Frequency Trading (HFT) has been going on for years now, but it has recently come to a fever pitch.  There have been at least two Congressional Subcommittee hearings related to HFT in the last 4 months.  CNBC has been covering HFT more often, as more and more trading related market structure issues are exposed every day.  There was a recent article in the Wall Street Journal about a former trader, Haim Bodek, detailing claims of “unfair trading practices” tied to HFT.  Many of the articles and comments on this forum are directly related to HFT, either espousing the benefits, or warning of the dangers of this contentious practice.  But there has been one voice that has been sorely missing from this debate, and it is that of the SEC.

So what does the Commission think about High Frequency Trading?  Sadly, it’s incredibly hard to say, and much of what has been happening in the last two months has only left me scratching my head, even more confused than before.  This feeling of confusion has progressively gotten worse, finally coming to an apex last week with the SEC’s fine of the NYSE.  For those not familiar with the settlement, the NYSE was fined 5 million dollars for having a “materially different” speed with which they disseminated data to the public, and the feed which they sold to a much smaller group of consumers.  Perhaps the most interesting quote in the SEC’s press release came from Robert Khuzami, Director of the SEC’s division of enforcement, who said:

"Improper early access to market data, even measured in milliseconds, can in today's markets be a real and substantial advantage that disproportionately disadvantages retail and long-term investors.  That is why SEC rules mandate that exchanges give the public fair access to basic market data. Compliance with these rules is especially important given exchanges' for-profit business interests"

For a second my heart skipped a beat after reading that quote.  The SEC seemed to “get it”; they seemed to understand some of the potential dangers that had been introduced into the marketplace in the last decade, and more specifically they seemed to understand that speed, even small amounts of it, could be a massive advantage to HFT’s at the disadvantage of the retail and long-term investor!

The elation didn’t last long.  My mind only had to think back to the release a few weeks before, with the NYSE stating that they were now going to be charging for direct feeds to their options market data.  How could that be?  After everything the latest case seemed to stand for, the SEC is apparently ok with an exchange (the NYSE no less!) charging a relatively large amount of money for a “direct market data feed”.  The only reason it would make sense to pay for a direct feed would be if that feed was faster than the feed I could get from Options Price Reporting Authority (OPRA).  More importantly, and perhaps more damning, the only way it would make sense for a market participant to pay for that feed would be if there was a material advantage to paying for the feed, vs. consuming the publicly available data.  And for those counting, it appears that the differential in speed between the NYSE direct feed and the OPRA feed is on the order of 6-7 milliseconds.

Surely the SEC would take the same view on this new practice, and come out and say “this is not fair, and creates an uneven playing field”?  As of right now, I have not seen anything from the SEC commenting on this.  All of my discussions with the NYSE lead me to believe that they think the fine was an isolated incident, and it will not impact their plans to continue to charge for direct feeds in both the equity and option space.  How could the SEC approve of charging for direct feeds, and fine the NYSE for doing what sounds like the exact same thing, at the same time?

Sadly, the confusion doesn’t stop with differentiated market data. HFT firms and exchanges have been accused of capitalizing on murky routing practices and biased order types.  In the recent Wall Street Journal article about former trader Haim Bodek, there are sweeping allegations that the US Equity exchanges offered order types that unfairly benefitted certain market participants, namely High Frequency Traders.  One passage from that article reads:

“…on Feb. 24, 2012, the head of the SEC enforcement group's market-abuse unit, Daniel Hawke, said at a law conference that the SEC was examining computer-trading practices and the use of order types. He told the group the agency also was looking into ties between exchanges and high-speed firms and was interested in the firms' ownership structure. Mr. Hawke declined to comment for this article.

A day before his speech, BATS disclosed in a regulatory filing that the SEC had asked it about the "use of order types, and our communications with certain market participants." BATS said the probe focused on communications it had with "certain of our members affiliated with certain of our stockholders and directors." High-frequency trading firms are among the BATS exchange's owners. The same is true of Direct Edge.”

Reading this article, one would be left with the distinct impression that the SEC was taking a hard look at order types, and their potential negative impact on the marketplace.  The confusion sets in when you look at the new PL Select order type recently introduced by the NYSE.  This order type is basically dark liquidity that will allow you to select not trade with an IOC order, an ISO order, or any order that is larger than the size of your order.  Another way to say it is that this is an order that will allow you to avoid interacting with the most sophisticated orders, and the largest orders, interacting with ONLY small limit orders.  Yet another way to say it would be that this is an order type will allow HFT’s to “penny” the market with dark liquidity that will ONLY trade with a small, generally unsophisticated order.  But you don’t have to take my word for it.  In what seems like a fairly unusual move, T Rowe Price has actually written a comment letter to the SEC opposing this order type (!!).  At the same time as the SEC is being alerted to potential problems and issues with order types, they are approving an order type that one of the biggest institutional money managers has written a comment letter specifically outlining the detrimental effects this will have on the marketplace, and the ultimate cost born by the very investors the Commission is charged with defending.

There are more examples as well; just this past week we have had a mini-crash in oil related to the erroneous reports about the strategic oil reserve.  We also saw a mini-crash up in a hand full of oil stocks the following day, with liquidity fleeing the market at the time its most needed.  Knight Trading nearly imploded due to a trading glitch.  It’s difficult to believe that these “market events” aren’t directly tied to the speed of trading, and at least in some way to the “high frequency trading” community.  Yet the SEC remains almost deafeningly silent on the issue.

What we need now from the SEC is leadership.  The SEC does not have to have all of the answers to every question about High Frequency Trading, or the ability to definitively say “high frequency trading is good/bad”.  After all, it is an incredibly difficult and complex issue.  But the SEC should be more public about what they are looking at, and they should be interacting with more market participants to help shape their view.  The SEC should bring some guidelines to the marketplace that can help guide while they digest all of the issues currently facing the industry.  It doesn’t make sense to have a regulator that is condemning a practice one day, and apparently condoning it the next. 

There are undoubtedly many significant benefits that electronic and high frequency trading have brought to the marketplace, and we want to work hard to keep those in place.  Competition and technology are at the core of our innovative capital markets, though this must take place on a transparent and even playing field for the benefits to accrue appropriately. There are many aspects of the current market structure that appear to be broken, for lack of a better word.  Instead of continuing the move down the same path that got us here, and escalating the order routing and market data differentiation that potentially got us into this mess, we should hit “pause”.

In the interest of the long term viability of the marketplace, we should temporarily halt “progress and innovation” until we have a clearer picture on what is helping and what is hurting.  This is a gargantuan task that the SEC is only making more difficult by continuing to let the market evolve at a “high frequency trading” pace.

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2 Comments to "We Need Leadership ":
  • Anon_avatar
    Andy Nybo

    27 September 2012


    You bring up a number of points that are often raised in my discussions with market makers and broker dealers in derivatives markets. Mixed messages from the SEC only increase the cost of legal compliance for securities market participants subject to SEC oversight. Add to that the increased regulatory oversight of the CFTC and the prospect for rising compliance costs is virtually guaranteed.  This issue is clearly on the minds of the brokerage industry.  TABB is working on a number of studies examining the evolving business environment for securities firms and many firms are identifying regulatory compliance costs as an expense item that is spiraling out of control.  Clear and consistent rules that are broadly disseminated by the SEC would go a long way to in reducing compliance costs of operating as dealers and brokers in US securities markets.

  • Missing

    28 September 2012

    Leadership at the SEC (or CFTC or FINRA)? You won't get it. The revolving door between regulators, industry titans and Congress is a whirlwind of corruption and avarice. That will not change, not without a serious overhaul of the regulators' and Congress' membership.

    "Operations executives from the four largest operators of national stock exchanges, as well as heads of technology from brokerages and trading firms will take part in Tuesday’s Securities and Exchange Commission roundtable on the stability of market technology."

    Where are the professors of finance and economics? Where are the unbiased or at least counter biased experts? How can there be balance in such a "round table" when the seats are all filled by only those who speak to benefit the corporate financial industry?

    This is how the financial regulators and Congress represent the U.S. Citizens: not at all.


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