Divine HFT Providence?

In the interest of full disclosure, I briefly worked for the City of Providence one summer back in college, and one of my favorite memories of that plucky New England town is showing up every sultry July morning, instantly cooled by its grandiose, musty, poorly-lit, Second Empire-style city hall building, which seems more like a set from a period film than a place of 21^st century municipal governance. The city's mayoral history is just as colorful, for those interested.

In a way, this all perfectly fits the image of investors disadvantaged by high-frequency trading (HFT). A small city in the nation's smallest state calling out massive financial institutions for allegedly violating Securities and Exchange Commission (SEC) rules is quite literally Main Street (or in Providence's case, Dorrance Street) battling Wall Street.

Reaping What You Sow
But obviously, it's not that simple. While the suit plays itself out, what can we take away from it so far?

First, and though we all might be a little tired of hearing about it, Flash Boys continues to burnish itself as a marker in the HFT debate, for better or worse. Somewhat ridiculously, City of Providence v. BATS Global Markets Inc, et al, mentions the book on page ... 2.  While I little doubt that the suit was under way well before Michael Lewis's book was published, the timing of all this does seem more than a coincidence, and the more industry sources we hear from, the more it seems that, owing to a variety of circumstances, 2014 was going to be the year this all came to a head.

A second possible outcome—and a more important one because it has less to do with suit's actual outcome and more to do with the buy side—is that caretakers of public money, like municipalities or pension funds, might just be more observant of the way their asset managers, their asset managers' banking partners, and discount brokerages all participate in the market than in the past. This is a good thing, because it means they'll learn more about the technology and relationships undergirding the reasons why a price is bad, rather than just bemoaning “rigged” markets. Probably the most lurid and consequential accusations of the complainants’ filing is the practice of “rebate arbitrage.” Should that practice be found to cause injury, significant long-term consequences for the way the electronic execution business works would have to follow.

The third consequence, though, is that we now know just how much confusion still exists about HFT, even—and perhaps especially—among the lawyers who are now circling like sharks around the issue. For example, single-stock futures (SSF) specialist OneChicago, one of the originally named defendants in the suit, has since been removed from the suit less than a week after it was brought. OneChicago's clients use SSFs to take advantage of optimal rates for equity financing, and none of the potentially perverse incentives or HFT shops involved in equities microstructure carry over, even remotely. So how did it end up in the suit?

When I spoke this week with David Downey, OneChicago's CEO, he reasoned it was a case of "mistaken identity" having to do with the venue's SEC Code 6 registration, which—despite being under an entirely different category than the exchanges involved—warranted OneChicago's inclusion in the lawyers' evidently untrained eyes. But that is indicative of the hoopla, rather than reasoning, still guiding the HFT narrative.

"There's blood in the water now," Downey told me. “And everybody is up in arms now because it's been sensationalized. But it comes down to the SEC allowing this to happen with Regulation NMS a long time ago, especially payment-for-orderflow and internalization. It's going to be very hard to prove anything illegal happened here, because it was all blessed by the regulators. It's not illegal, just abusive. When Interactive Brokers founder Thomas Peterffy said the same things we're talking about now in 2010, he was given tons of grief, but this is why traditional liquidity providers have pulled away, because they simply won't buck up the $20 million in takes every quarter to grab that extra millisecond. And this all starts with the model of buying offers and selling bids. It should be the other way around."

Legal hastiness might mean the suit ends up going nowhere, fast. But if the issue continues to hang around in heads as far up the buy-side stream as a city government, it is certain not to go away.

Deep in the Heart of Texas
Anthony returns to this space next week following his maiden voyage to Tokyo, and I'm sure he'll have no shortage of tales to impart. Meanwhile, I am headed to another US state capital that punches way above its weight—Austin, Texas—for the annual Options Industry Conference.

I look forward to running into our readers there, and anyone working on new tools helping the buy side tackle complex spread options should feel free to shoot me an email (timothy.murray@incisivemedia.com), or find me at one of Austin's seemingly endless supply of delicious BBQ shacks.