In a recent speech, Senator Ted Kaufman (D, DE) highlighted what he saw as the dangers of high frequency trading and outlined a number of points for regulators such as the SEC to consider.
It was a pretty well-informed speech. Sen Kaufman has obviously taken the time to speak with various people who seem to know what they are talking about, including representatives from trading firms, hedge funds, banks, brokers and of course regulators.
This is not the first time that Sen Kaufman has talked about transparency (or as he sees it, the growing lack of it) in the equities markets. However, as he said himself, the “markets have outpaced regulatory understanding” and now we’ve reached a point where the combination of high frequency trading and lack of transparency is threatening the overall credibility and stability of those markets.
Regulators, as ever, are having to play a game of catch-up. As it was with credit derivatives, so it seems to be with high-frequency trading. Regulators often don’t really understand what is going on – in terms of the intricacies of what the players are actually doing and how they are using a new product or a new technology – until something painful happens to make them aware.
Not that I’m advocating over-regulation of high frequency trading, I’m just making the point that the regulators seem to be struggling to get their heads around what constitutes acceptable practice versus what constitutes manipulative, predatory of front-running activities. The danger is of course that without this understanding they will just regulate the whole thing out of existence.
The SEC has of course had a consultation paper out for a couple of months now and is no doubt gathering a wealth of information from all corners. It remains to be seen however how the SEC will use this information and what kind of regulations they will implement. To date, most of their energy has been focused upon outlawing naked unfiltered access to electronic exchanges by non-members. Fair enough, there is definitely potential for someone’s unfiltered algorithm to cause havoc with the way things currently stand.
But Sen. Kaufman focused on five key points that the SEC, and market regulators in general, should concentrate on. Here are his recommendations in a nutshell.
1) Give better guidance to market participants on what is and what isn’t acceptable. His view (and it’s a view shared by many) is that there isn’t enough clarity at the moment on various issues related to high frequency trading, including naked/sponsored access, flash orders and co-location. With better guidance and greater clarity, he argues, the markets will regain some of their dwindling credibility and stability.
2) The regulators need to gain a better understanding of who exactly is doing what when it comes to high frequency trading, how they are doing it and how it affects other market participants. And this data should be made widely available and open to public scrutiny. Sen. Kaufman, along with many other observers no doubt, wants to see much greater transparency in the markets.
3) There needs to be a clear set of definitions from regulatory bodies on what actually constitutes manipulative activity. Any definitions that currently exist need to be brought up to date to account for the rise of high frequency trading and other practices that didn’t exist when current regulations were originally drawn up.
4) The SEC must focus on reducing operational risk and the potential damage to the markets from widespread systemic risk. Sen. Kaufman wants to see exchanges imposing universal pre-trade risk checks, so that no orders can be sent into the electronic markets without first being checked against pre-defined limits.
Of course, one of the reasons why brokers offer naked access to their clients in the first place is so that orders can be sent into the exchanges and MTFs with extremely low latency (tens of microseconds in some cases). Running orders through pre-trade risk checks always results in an increase in latency. However, if it this were to become a regulatory requirement, all market participants would be equally impacted. And in that case, brokers would need to seek out the fastest pre-trade limit/risk checking systems (which would no doubt be good business for software vendors like ULLINK who offer such technology).
5) Finally, Sen. Kaufman seems to have jumped on the bandwagon of people calling for a tax or a fee on order cancellations. This proposal, whereby firms would only be allowed to send a specific number of order cancellations into the market before incurring a cancellation tax, seems to be gathering a lot of support among those looking to limit high-frequency trading. The reason? Because many (if not most) high-frequency trading strategies work by sending orders into the market at high speed in order to expose liquidity and then canceling those orders before they have a chance to be executed. So a cancellation tax could actually sound the death knell for high frequency traders.
We will continue to watch Senator Kaufman’s initiatives around high frequency trading regulation with a great deal of interest.
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