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In Advance Of Today's SEC Hearing On High Frequency Trading

Tyler Durden's picture




 

Today, the SEC is convening a one-sided panel whose job is to provide a fair and balanced view of high frequency trading but in reality is just a industry-lobby group which will fight tooth and nail to prevent any changes in regulation to the cushy two-tiered market gambling structure that has developed courtesy of a bunch of math Ph.D. and astrophysicists determining just what market momentum is (or isn't as May 6 so amply demonstrated). In advance of this "panel", the NY Observer's Max Abelson provides an amusing report on HFT in his piece the "High-Frequency Talker" which portrays precisely the kind of people who churn AMZN billions of times of day while having no clue what it is the firm does, what its EBITDA is (or what EBITDA is period), or what its EPS prospects are. For a more serious perspective from one of the few who has consistently warned about the threats of HFT and broken market structure, we provide the following speech prepared by Senator Ted Kaufman. We can only hope that someone at the SEC has at least one tenth the knowledge required to understand just how critical the Senator's warning is. We can only hope that the events of May 6 have forced the SEC to redirect their attention from online pornography for at least 24 hours.

“In assessing the breadth of each panel invited to participate tomorrow at the SEC roundtable, there are two questions to ask:  Will the participants represent a broad range of industry members and outside experts? And will each panel present a wide and fairly balanced range of viewpoints?  As I said last Thursday, the Commission at a minimum should ensure that all of the panels demonstrate “some semblance of balance” between industry participants who profit from the current market structure and critics who fault the markets as overly fragmented, conflicted and unfair.

“With preliminary reports last week showing the make-up of the high frequency trading panel to be dramatically out of balance, the Commission, apparently in response to my concerns, moved one of the biggest past advocates for high frequency trading to another panel and added a mutual fund critic as well as another representative from the academic community.  That means on the high frequency panel, two are previous critics of high frequency trading and two are academics.  Of the other five on the panel, four make their living either directly or indirectly through high frequency trading and all five, for the most part, have been staunch defenders of the status quo.  Draw your own conclusions about whether this is a ‘balanced’ panel. 

“The panels would certainly have benefited from a few more high frequency critics (like Rich Gates of TFS Capital, O. Mason Hawkins of Southeastern Asset Management or Bob Bright or Dennis Dick of Bright Trading) as well as representatives of a pro-investor group, such as the AFL-CIO from the perspective of pension funds, or David Weild of Grant Thornton, which has conducted studies on whether the current market structure is having a devastating effect on Initial Public Offerings (IPOs) and capital formation. 

“Candidly, I remain deeply troubled that the Commission under the glare of public scrutiny had to scramble belatedly to ensure that these panels pass even minimal criteria for balance.”

Kaufman also outlined three larger issues he believes the SEC must address:

(1)    Breaking the “Closed Loop” of Rulemaking, i.e., Evidenced-Based Rulemaking When Only Wall Street Controls the Data

The SEC must base its rulemakings on data and evidence.  That is a problem when (a) it doesn’t collect meaningful data about high frequency trading – that is what the proposed “large trader” rule issued on April 14 is meant to rectify, when if finalized and implemented the SEC will for the first time “tag” and collect data at the time and customer level about high frequency trading practices; and (b) no one has access to that data outside the high frequency trading firms themselves.

Currently it is a “closed loop” where the SEC is almost exclusively dependent on the entities it regulates for analysis and evidence.  What we need is for the SEC to require 100% tagging of trades (equity and derivative) and messaging, sent back to the investor, and then to disgorge this data into the public marketplace on a delayed basis.  We don't know what we don't know means systemic risk.

To address this major gap, the financial reform bill passed by the Senate includes a new Office of Financial Research within the Treasury Department.  The new office would have the authority to collect and analyze financial data in order to identify and assess incipient risks in the system.  It would also publish databases on financial institutions and contracts, which would facilitate further analysis by academics and other independent reviewers.  I would hope that analyzing the systemic risks associated with high frequency trading would be a top priority of the new office.     

(2)    Academics and Private Analytic Firms Need to Play an Important Function

Only after meaningful data is collected and released to the marketplace can academics and private analytic firms provide additional objective evidence to the SEC about market structure issues. 

The academics (and also the private analytic firms that work for the buy-side) should be best positioned to frame (a) the post-May 6 issues, especially the disappearance of liquidity, and (b) what data is needed to conduct meaningful empirical analyses to resolve key issues in the debate.
 
Again, the key point is that we need to get meaningful ("large trader" at time of order and customer level) data to the academics and others because in my view they are currently unable to verify empirically most of the key questions.  

If anyone in the aftermath of May 6 jumps to conclusions based on broad market data, in my view that will be disappointing, premature and superficial.  Or, ideally, the academics and buy-side analytic firms  will educate everyone on what data is available and meaningful in answering certain questions as well as what data is not available that is necessary to measure other effects. 

(3)    Costs Should be Allocated Fairly

The SEC may need to take further rulemaking.  Without prejudging what those rules should be, to me it is obvious that regulators must address the burgeoning message traffic and cancellation rates in the current marketplace.  While cancellations are not inherently bad – potentially enhancing liquidity by affording automated traders greater flexibility when posting quotes – their use in today’s marketplace is clearly excessive.  At a minimum we need a system (as a growing number of people are proposing) whereby exchanges and market centers are mandated by rule to allocate costs at least partially based on message traffic share rather than traded volume market share. 

If the SEC adopted a similar system for the new audit trail, high frequency trading firms – some of which cancel hundreds of orders for every one transaction – would have a significant incentive to become more efficient. This would greatly reduce message traffic, system stress and marketplace noise, and would make the markets easier for regulators to surveil as well as add a much needed degree of fairness.

 

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Wed, 06/02/2010 - 08:59 | 389052 Salinger
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Wed, 06/02/2010 - 08:40 | 389053 blindman
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http://maxkeiser.com/

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June 1st, 2010 by stacyherbert
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Stacy Summary: This episode, we compare the BP offshore toxic oil spill crisis to the toxic derivatives spill polluting global financial system. In the second half of the show, Max interviews Heidi Moore of Slate’s TheBigMoney.com about movie futures, financial innovation and financial reform.

Wed, 06/02/2010 - 08:41 | 389054 Hephasteus
Hephasteus's picture

I still say High Amplitude trading is the future. The beta tests with the huge pip moves are going good.

1000 points in 6 seconds.

High Amplitude Bitches!!!!

Wed, 06/02/2010 - 08:47 | 389061 mister_x
mister_x's picture

Any threat to HFT will lead to the immediate shutdown of our co-located magic boxes. You know what happened the last time we did that. Not a threat, just a friendly warning.

Sincerely,

The HFT Nerds

 

Wed, 06/02/2010 - 09:03 | 389087 MarketFox
MarketFox's picture

Here it is....

Defragmentation of ALL exchanges.

Equal access to all account types....meaning no account minimums and no day trading margin rules....simple.... the customer, retail or not can choose from 1:1 to 10:1....and can open an account with as little as $500.....

No short sale rule....the short total quantity is capped at shares outstanding...

There will be share size limitations....as this relates to TOO BIG TO TRADE....and TOO BIG TO FAIL....this goes hand in hand....

All trades have a one second minimum stay....

The regulators could actually effectively electronically regulate such an exchange....

Absolutely no order matching of any kind off the exchange....no dark pools etc...

All countries should make all securities tax free in every way....in the name of efficient capital....

The BATS model should be utilized....and perhaps the exchange should be located in a neutral state ...ie Switzerland....

 

Wed, 06/02/2010 - 09:19 | 389121 LeBalance
LeBalance's picture

"that has developed courtesy of a bunch of math Ph.D. and astrophysicists determining just what market momentum is"

Oh yeah, the Banksters didn't pay for software, it was just a bunch of pencil-necks the whole time.

/sarcasm off/

Wed, 06/02/2010 - 09:28 | 389135 peterpeter
peterpeter's picture

> If the SEC adopted a similar system for the new audit trail, high frequency
> trading firms – some of which cancel hundreds of orders for every one
> transaction – would have a significant incentive to become more efficient.

There is nothing wrong with passing on small costs for placing and/or cancelling orders to recoup the costs of the SEC's dream data repository, however those costs get passed on directly to investors and other speculators (which is what most people carping about HFT are - just slower speculators) in the way of spreads which widen out to compensate for the added costs of running the HFT business.

Given how competitive HFT is (with margins per share estimates by TradeBot of $0.001 per share), each firm seeks to place orders with the slightest statistical profitability. When an order becomes unprofitable because of added costs associated with cancelling that order if pricing information changes (or nuttier proposals like minimum order resting time), it never gets placed at the price it would be posted at today. This in turn reduced liquidity and thwarts price discovery somewhat (because an order at the NBBO that is left unfilled does help price formation by telling participants that others believe the price is better than the posted bid or ask).

Senator Kaufman is right to look at the funding mechanism for the multi-billion dollar SEC data warehouse, and there is nothing wrong with imposing a order placement or cancellation tax per se, but it is clear that literally any added costs passed on to liquidity providers (HFT or otherwise) will be borne by investors.

Wed, 06/02/2010 - 09:55 | 389193 Robslob
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Spoken like a true banker...

Wed, 06/02/2010 - 09:59 | 389212 Jack Ryan
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Would someone please bring a High School Econ teacher to explain that taking spreads from 1/4 to 1/8 to 1/16 eliminated the rent required to provide liquidity that has been absorbed by HFT?  Liquidity isn't free and the HFT guys are charging it when they can make money from it, but that means that when bids disappear, so does liquidity. 

Wed, 06/02/2010 - 12:33 | 389607 sid farkas
sid farkas's picture

"when bids disappear, so does liquidity."

I see you are a professor of tautology. Let me be the first to welcome you to America where you are free to create an HFT system that provides liquidity even when it will lose money.

Do NOT follow this link or you will be banned from the site!