Wednesday, March 19, 2014
Thanks for inviting me to guest blog. As Stefan said, my area is corporate governance with particular interests in the rights and responsibilities of corporations in society, and how changing market dynamics impact corporations. In that vein, I had the pleasure of moderating a panel discussion yesterday at New York Law School on High Frequency Traders (HFTs). The panel immediately followed an announcement by New York Attorney General Eric Schneiderman on new proposals targeted at HFT firms (part of what his office terms their “Insider Trading 2.0” initiative).We certainly had a lively discourse and a link to the full panel discussion will be available shortly— I’ll be sure to post at that time. But in short, here are the highlights:
High frequency traders use a fully automated trading system to move in and out of securities at a rapid speed, often just in milliseconds. To get a sense of what is at stake, consider that by constructing a high-speed fiber optic cable, round-trip communication time between New York and Chicago was reduced from 16ms to 13ms, and now using microwave technology, the round-trip transmission time was further reduced to 10ms, then to 9ms, and most recently to 8.5ms. What can a HFT do in a millisecond? Turns out— a lot. One HFT who is about to go public, disclosed in its IPO filings that out of 1,238 trading days it made a profit on all but one of those trading days— https://www.sec.gov/Archives/edgar/data/1592386/000104746914002070/a2218589zs-1.htm.Thus, there is this arms race to build the most super and fastest computer because whoever is fastest stands to be rewarded handsomely.
AG Schneiderman noted that several HFTs were getting an unfair edge on the rest of the market by paying news aggregators a fee to get a peek at market-moving information a few seconds before this information was distributed to the rest of the market. Moreover, to increase the speed at which they receive data, several HFTs pay a fee to the stock exchanges to co-locate within the exchange— again, all with an eye to getting a split second head start on the rest of the market. Now a split second head start may not seem like much, but when combined with their ultra high speed networks, a split second head start allows HFTs to leapfrog over the rest of the market and quickly extract profit. How much profit are we talking about? On each trade, not much— typically, just a couple of cents. But, according to AG Schneiderman by making several hundreds of thousands of trades each day, it is estimated that HFTs make billions of dollars each year.
Proponents of HFTs argue that HFTs serve a market-making function, they increase liquidity, and improve efficiency, and they are quick to point out that the HFT trading framework is perfectly legal. However, concerns loom large about the unfair edge that HFTs have, and also about market destabilization. In terms of destabilization, at least two events come to mind – (i) the May 2010 “flash crash”, which was blamed on high frequency traders, and (ii) last April’s trading frenzy in response to a tweet which falsely reported explosions at the White House— the frenzied wave of trading was linked to HFTs and it caused the Dow to lose 143 points in less than a minute.
So, what is being done about HFTs? And should something be done?
Currently, the SEC has succeeded in getting the major stock exchanges to agree to a circuit breaker, which would halt high-speed trades during emergencies. AG Schneiderman proposed a different solution, which would be to modify the market structure design. Currently, the predominant market design is the continuous limit order book market design. Under this design, orders are processed by the exchange in serial, meaning that orders are accepted and matched based on which order arrives first. This system benefits HFTs because in effect it rewards the best speed and not necessarily the best price. One proposal from economists at the University of Chicago would be to change from the current continuous limit order design to a frequent batch auction system (a link to a draft of the paper is available here— http://faculty.chicagobooth.edu/eric.budish/research/HFT-FrequentBatchAuctions.pdf). According to the AG, this proposal would put a "speed bump" in place so that orders would be processed in batches after short intervals (for example, one second intervals). The idea is that this would better ensure that price not speed would be the determinative factor in who obtains the trade.
In closing, let me venture to say that we should expect more focus from regulators, SROs, policy makers, the media, and academics on HFTs. HFTs realize that it’s about to get ugly and so they are being proactive and according to the WSJ, have “hired a pair of heavy-hitting political strategists and formed a trade group to press their case with regulators and law makers.” Top of their list is to get people like me to stop referring to them as HFTs, as they would prefer to be called “automated professional traders” — http://online.wsj.com/news/articles/SB20001424052702304887104579302681366721324 .
Now beyond semantics and technological fixes, HFTs present broader policy questions and concerns.
For one, is the insider trading framework the right framework for addressing HFTs? AG Schneiderman’s office realizes that the current insider trading framework is not an exact fit, but the view is that HFTs represent a new flavor of insider trading (hence the term “insider trading 2.0”).
Second, how do we draw the line between legitimate information gathering and predatory trading behavior ? What is our normative framework?
Third, to the extent we accept that something needs to be done about HFTs, who should take the lead? The SEC? The states? The stock exchanges?
And fourth, do the traditional proxies of measuring “benefits” and “success” still work in today’s age? For example, HFTs use positively associated terms such as “liquidity” and “market making” to defend their activities, but according to one panelist we need to be careful about using “a lot of terminology and measurements that are related to the way the markets used to work.”