Curbs on high-frequency trading gather pace
Aug 11, 2009
SEC and others target flash and cancel-on-initiation orders
High frequency trading (HFT), the lightening-fast algorithmic trading of stocks that, by some estimates, accounts for half to two thirds of total printed volume, will see its wings clipped as a result of public scrutiny following a negative front-page story in the New York Times.
In particular, abusive ‘flash’ and ‘cancel on initiation’ orders, which can be used to facilitate front-running legitimate order flow, has been explicitly targeted for action by the SEC following the Times’ article and a follow-on prod from Senator Charles Schumer.
The nail in the coffin was potentially dealt by NASDAQ OMX late last week when the exchange announced it was eliminating the practice from September 1, and called on other markets to follow suit. Since the article first put the growing practice in the spotlight, public statements, letters to clients and press releases have been coming thick and fast.
On Friday, July 24, New York Times financial reporter Charles Duhigg described systems ‘so fast they can outsmart or outrun other investors, humans and computers alike’, and illustrated how some savvy traders are profiting by using the information edge that flash orders give them to ferret out and front-run order flow.
Before the end of the day, Senator Schumer had reportedly issued a letter to the SEC, calling on the agency to prohibit the practice and threatening to introduce legislation to the same effect. (Senator Schumer’s office did not respond to several requests for a copy of this letter, and SEC spokesperson Kevin Callahan says the commission ‘does not comment on communication between the agency and members of congress.’)
Recognizing the sensitivity of the issue with its institutional clients, the following week Goldman Sachs wrote a one-page letter to clients that was picked up by bloggers. The letter reassured clients that ‘Goldman Sachs does not make use of flash programs in the execution of client agency orders’ and that its HFT platform ‘does not see client order flow’. It went on to state that ‘those who participate in HFT… should assume additional obligations and be subject to appropriate regulatory oversight.’
On Tuesday, August 4, seven working days after the original article, SEC chairman Mary Schapiro issued a statement saying the agency is looking ‘for an approach that can be quickly implemented to eliminate the inequity that results from flash orders’, and Senator Schumer issued a press release saying the chairman ‘pledges that a ban is imminent.’ Two days later, NASDAQ issued its announcement.
While gratifying for critics of the abusive practice to see it coming to an end, the issues of transparency and price discovery in the electronic trading environment have not been totally invisible either to the SEC or to industry insiders.
In June this year, Schapiro expressed concern that off-market dark pool information flow could impair price discovery and exclude open market access. While she did not explicitly challenge abusive HFT practices, she did indicate that regulatory solutions were being sought to ‘protect market integrity’ from ‘the emerging risks posed by dark pools.’
IROs at the June NIRI conference were educated on dark pools and flash trading, among other topics, at a standing-room-only session titled, ‘How the buy side and sell side trade your stock’, which attendees have been talking about ever since.
Tim Quast, managing director of Modern IR, a market intelligence consulting firm, moderated the session. He described flash and cancel-on-initiation orders as ‘forms of front-running the crowd’ that should be banned, but said that HFT in general is not a problem. ‘By the time regulators and the media turn their attention to it... the market has adjusted to it,’ he noted. Given the new market structures, Quast believes HFT technologies are here to stay and ‘vilifying HFT as a whole is incorrect.’
HFT ‘has essentially become the specialist of today,’ Quast added. Where traditional specialists committed capital, HFT platforms ‘supply technology and liquidity’, which is what the market wants.
By Brad Allen