Defining high-frequency trading’s US level of evil

June 20, 2014 7:28 pm

Defining high-frequency trading’s US level of evil

By John Dizard

John Dizard considers whether there is enough liquidity in equity markets

The Wall Street/Washington policy world tends to agree with its European counterparts that there is a worrying lack of liquidity in the credit markets. Most people do not worry much about that as long as the dryness goes along with rising prices; it is during the falling-price times that talking heads worry about liquidity.

There is not so much of a consensus on whether there is enough liquidity, or ability to readily buy, and, especially, sell, in the equity markets. On Wall Street, people’s sentiments about high-frequency equities trading is largely determined by whether they believe there is plenty of liquidity to go around, or not. (In Europe, there is agreement across the political spectrum that HFT is inherently evil.)

As long as there are enough buyers for all the sellers (people usually do not worry so much about the converse condition), Wall Street is inclined to take an amused, boys-will-be-boys attitude towards HFT. The larger investing public is apparently not worried; after all, they have always been able to cash in their mutual fund or exchange traded fund shares, and always will . . . right? Right?

The Securities and Exchange Commission and Congress do what they have always done when serious questions come up: they start a seemingly endless process. SEC chairman Mary Jo White earlier this month made a very serious speech that promised the regulator would be “Addressing High-Frequency Trading and Promoting Fairness”.

My own view is that there is a lot of liquidity in the equity markets, except when it is really needed. I also believe the mismatch between what most investors think is just like cash in the bank and what is cash in the bank is larger than ever.

Not every serious person agrees with me. Joseph Brennan, the head of Vanguard’s $1.7tn global equity index group, says “equity markets do not have a liquidity problem. We can trade up to $10bn [of shares] a day, though most days it would be $1bn to $2bn.”

For that matter, he says, “sometimes, when there is high volatility in some markets, liquidity actually increases. [That was the case] with the Russia-Ukraine situation, where liquidity in Russian equities actually went up, as it brought in players who had not been trafficking in Russian securities. It doesn’t always go up [in such circumstances], but it can.”

Mr Brennan is also not as concerned as some with the operations of high-frequency traders, though, as he points out, “There is no standard, generally accepted definition of what HFT is. Sometimes, those who could be defined as HFTs act in a way that makes markets [ie are sellers to buyers and buyers to sellers]. Sometimes they fill in the gaps of a fragmented market structure. A significant amount of [this] activity is in the interest of the investing public.”

While Mr Brennan would like some reforms in that “fragmented market structure” in the US, he says “anything we look at should be ‘pilot modelled’ first”.

Mr Brennan’s view is fairly representative of the largest mutual fund firms. Thomas Peterffy, chief executive of Interactive Brokers, one of the largest automated electronic brokers and market makers, has a very different point of view. Basically, he thinks that HFTs (remember definitions vary) often act to reduce liquidity when it is needed, and need some very specific controls.

He has submitted an interesting, somewhat technically challenging, proposal in a letter to the SEC. As it says, “We would like to recommend that all US equity and options trading venues be mandated to hold any order that would remove liquidity for a random period of time lasting between 10 and 200 milliseconds before releasing it to the matching engines.”

Got that? Of course. Essentially, Mr Peterffy is saying that the National Market System was designed for much slower computation and communication speeds than are now available, the rules are too easy to game, and you cannot really buy and sell all the time as easily as it appears you can.

“We know all about the speed advantages of HFTs because we have to keep up with them,” he says. “We will do things where we can gain as little as a tenth of a millisecond. But that is crazy, because it does not increase economic value.”

He agrees with academic estimates that the entire direct cost of HFT is only in the low single-digit billions. “But the damage is much bigger, because they compete with longer-term liquidity providers [such as Interactive Brokers], so there is actually lower liquidity as a result of their activities.”

Mr Peterffy set internal teams against each other to see if there was a way to beat his system, and, he asserts, they were unable to improve on its design. Of course he expects the SEC and every other interested party to test his proposal ruthlessly.

For my part, I am morally certain that nothing of consequence will be done until after the next general equities crash. Not “decline”. Not “bear market”. Crash.

Then there will be serious consideration of What Should Be Done.