Curing What Ails US Equities: More 'Law and Order,' Less 'X-Files'

“It's not about being right, Mr. McCoy. It's about doing right. Now, we're adjourned.”

—Judge Wright, after overturning a guilty verdict, from Law and Order (1999)

I thought of this line, from the show's tenth season, during a conversation this week with Chris Nagy and Dave Lauer—two registered lobbyists, the former quoted in Flash Boys, Michael Lewis’ latest lightning rod. Together, the duo have experience on both sides of the narrative that Lewis laid out, re-igniting the embers of the high frequency trading (HFT) debate that have smoldered since the New York Times’ July 2009 piece, stoked again after the May 2010 Flash Crash. Lauer is a former technologist at Allston Trading and Citadel. Nagy previously headed up government relations for retail brokerage TD Ameritrade. Unsurprisingly, both have a lot to say on the subject.

But it’s what they didn’t focus on that surprised me. Nothing popped up about the FBI’s nascent investigation into whether HFT amounts to insider trading. Let’s remember that the FBI once put New York Yankees owner George Steinbrenner in its crosshairs, and still regularly investigates the fraudulent activities of countless believers in the extraterrestrial. (That doesn’t give us much, Mulder.) Likewise, and more to my befuddlement, the pair didn’t actually speak at any length about Flash Boys, itself. In fact, a recent academic paper from Robert Battalio, a professor at Notre Dame’s Mendoza School of Business, seemed their preferred point of reference. [It’s technical, but worth a read.]

The HFT debate in 2014 boils down to something like a choice between watching a high-wire circus joust, and a scientist trying to measure the force of gravity for the first time. The same phenomenon is at play in both cases. The former is noisy and entertaining, with one party righteously left standing at the end. The latter seems tedious, empirical, borderline monotonous—but it’s far more important. Why?

Ask the mutual funds that met the Securities and Exchange Commission’s (SEC’s) commissioners recently with concerns about “quote stuffing” practices, another source told me, only to be laughed out of the room for lack of quantitative evidence. Ask Charles Schwab, which in 2011 re-upped its $256 million agreement with UBS to route the majority of Schwab’s equities and options order flow through the Swiss bank’s high-speed securities arm—creating a singular relationship whose effects ripple out across the rest of the execution microstructure—but then this week described HFT as “a growing cancer” in the markets. Or do as Nagy did in an eye-opening moment when, while still at Ameritrade years ago, he asked veteran SEC counsel Daniel Gray how the regulator had settled on its 30 cents per 100-trade execution charge. Giving the most candid answer he could, Gray simply shrugged.

For all its discussion of “rigged” markets and HFT’s ascent from branded insurgency to alleged mom-and-pop slayer, Flash Boys nailed the sideshow (and created no small amount of its own) but, by itself, probably misses the greatest reason why we are where we are: desperation, driven in no small part by missing or asymmetrical information. That doesn’t make Lewis’ argument unimportant—just incomplete.

Tactical
One solution, and Lauer and Nagy's preferred approach, is to agree on piecemeal tactical steps rather than rip out high-speed trading wholesale or, worse, take steps toward criminalizing it. As Lauer put it, “Any regulation that targets a specific class of market participants is a huge mistake. If that’s your only option, then you’re already past the point of having screwed things up.”

Those steps could include extending the SEC’s Market Information Data Analytics System, known as Midas, to cover all resting indications of interest (IOIs) at the dark pools as well as immediate-or-cancel (IOC) orders on lit exchanges; modernizing SEC Rules 605 and 606 enforcing post-trade cost analysis provision; reworking the rebate-based routing conventions that Battalio argues costs end-customers as much as HFT does, itself; or introducing new trade-at rules that tackle what Lauer describes in numbers-theory terms as the “Hurst Component”—or increasing self-similarity—that characterizes the way market-makers provide liquidity today, and undermines in practical terms whatever greater breadth appears to be there on the surface.

Is it finally time to take those concrete options seriously, rather than arguing over what is “right”? I hope so, and I’m sure we’ll find quite a range of opinions on the subject this Tuesday as we kick off our conference season with the North American Trading Architecture Summit, in New York City.

I look forward to seeing many of our stateside readers there, and in the meantime, feel free to email me with your thoughts at timothy.murray@incisivemedia.com.