In Regulating HFT, Europe Misses the Target

Seen as a kitschy gift by many at the time, the bells had a deeper purpose, according to Wall Street Journal reporter Scott Patterson in his book Dark Pools. As well as being rung furiously in celebration of the newly formed NYSE Group, they were also designed to drown out the catcalls from established open-outcry traders, who could see their way of doing business coming to a close.

The explosion of high-frequency trading (HFT) was destined. Instinet had bought Island, an ECN that had facilitated the development of the trading strategy, and was absorbed by Nasdaq. The exchanges, which had traditionally been bastions against the all-electronic styles of trading propagated by these upstarts, caved in and profited nicely from maker-taker systems of commission, and from increased liquidity on their books, which had been steadily eroded over time by the Islands and Archipelagos.

Fast Forward
Island's technology would later be used in the creation of Chi-X in Europe, which would herald a new age of HFT in Europe. From being a strategy practiced by secretive firms named for acronyms of boring titles, or rivers in New York, it became widespread and accounted for enormous percentages of flow on US and EU stock markets.

Originally, it seemed, everyone was happy to have HFT. It provided liquidity, narrowed the crippling spreads that had long been the gravy train of traditional market-makers, and created efficiency—or so the story was told.

Then came the 2010 Flash Crash. While HFT may not have caused the event, it certainly exacerbated it, and it was firmly under the spotlight. It had been for years before, with less-advanced mutual funds, more traditional brokers, and retail investors complaining of being picked off by lightning-speed traders who managed to get in front and skew their own executions by virtue of being faster.

Yesterday's passing of Mifid II guidelines in Brussels isn't surprising. But it's not, perhaps, the best way to go about it. Minimum resting periods for orders aren't necessarily going to solve the root problems of HFT from a regulatory or systemic risk perspective.

From there on, it seemed almost a foregone conclusion that something had to be done. Nothing frightens people so much as something they don't understand, and there is not much more impenetrable to the outside spectator than speed-of-light equity trades, arbitrage strategies and scalping techniques.

Gaffes and Gambits
While the Flash Crash could be taken to be an isolated incident, a momentary glitch that caused a brief collapse and a revitalization minutes later, HFT continued to hit headlines. Mini crashes on indexes such as the Dax rang alarm bells, circuit breakers continued to be triggered in single stocks on a daily basis, and a series of unfortunate legal and operational hiccups, such as Goldman Sachs’ failed pursuit of ex-programmer Sergei Aleynikov and Knight Capital's spectacular near-implosion, kept dragging it back into the spotlight.

The tide was starting to turn. In foreign exchange (FX), protests against burgeoning HFT invasion had been the loudest, particularly among sell-side institutions—despite some of those releasing single-dealer platforms that catered to high-speed algorithmic trading—and has culminated in a number of anti-HFT initiatives. Other regulators—such as those in India and Australia—wary of the ongoing brawls in the US and EU over HFT, have sought to distance themselves from it.

Yesterday's passing of Mifid II guidelines in Brussels isn't surprising. But it's not the best way to go about it. Minimum resting periods for orders aren't necessarily going to solve the root problems of HFT from a regulatory or systemic risk perspective. These are the feedback loops such as those seen in the Flash Crash, in which algorithms sense problems and pull out, which then signals declining liquidity to other algos, which pull out, thus causing more declining liquidity, and so on. The other is the glitch risk, such as what happened to Knight, where technical problems cause a pump of orders and executions into a system, often so fast that it's hard to fully appreciate the impact of the problem until the thread has been cut.

It's difficult to see how posing minimum resting periods does anything other than inhibit the practice of HFT, and even then, not fully. If that's what you want to do, then fine, outlaw HFT. But dressing so much regulation up as noble moves toward guaranteeing the stability of the financial system, then regulating without that bigger picture in mind, is childish.