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High frequency traders: Saints or Sinners

If you need to establish a one-size-fits-all stance on whether high frequency trading (HFT) is good or bad, don’t bother.  The recent Bank for International Settlements (BIS) Markets Committee paper ‘High frequency trading in the foreign exchange market’ does a great job of helping to explain why market making and algorithmic flow may have similarities, yet is different, to HFT flow. It also clarifies why HFT differs between FX, equity and other markets, and thus why a single politically-acceptable sound bite either praising or demonising HFT just won’t do.

HFT provides liquidity to the market in some situations, but can cause, or at least amplify, problems of dramatic price falls when a price drop is sufficient to trigger further automated selling, as the flash crash demonstrated. Any specific regulatory control really does need to consider the: who/what/why/where/when of market activity. The consolidated audit trail (CAT) of order flow proposal, which both the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) are keen on, does appear to fit the bill to provide this type of investigation, albeit only as an after-the-event ‘witch hunt’ tool.

A consolidated audit trail is after-the-event because it is highly unlikely to attract the budget to do this in real-time. It is also unlikely to make the change in regulatory organisational make-up, to attract and incentivise the right type of people with deep experience of reverse-engineering market activity in order to close a ’flash crash’ stable door before the horse bolts; rather than working buyside or thereabouts to monetise their skills. 

More worrying though is the recurring proposal (threat?), that HFT firms will need to provide a copy of their code before it can be used in the market. Assuming conducting reviews in a timely manner is of the essence, there are bound to be issues. How can anyone expect the review team to understand all coding languages including proprietary ones, to consistently handle bugs found in the code in a sensible way and to deal in a timely manner with each code change made in what we know is a fast moving technology arms race?

What we have at the moment is a lot of politically-driven rhetoric about the dangers of HFT. The politicians and policymakers need to take a step back to consider the true complexity of the challenge. 

With other active regulation such as Dodd Frank being formed to mandate specific types of execution venues with specific order flows, it seems likely the HFT-focused regulators may ultimately conclude that regulating individual market types for particular types of transactions and/or counterparty types makes more sense. It is easier to regulate a world where HFT firms operate in markets where they only face counterparties who are, by their presence in that market, implicitly happy to face them. And if that was acknowledged as the future landscape, interaction between different types of markets would also be simpler to plan and implement, and of course there would be far less need to immediately conclude that all high frequency traders are either saints or sinners.

 

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