As more and more people voice their displeasure with the hijacking of the stock market by assorted HFT bucket shops (and oligopolies), with persistent defense by such industry participants as Irene Aldridge notwithstanding, we would like to present the latest opinion by Abel/Noser co-founder, Gene Noser (whose firm recently confirmed that just 99 stocks account for 50% of all daily trading volume) who explains where, in his view, we went wrong with market structure, courtesy of the ever accelerating technological encroachment, and provides five suggestions on how to fix the market, and begin to eliminate the various parasitic influences of the HFT fake-market making brigade.
Whose Stock Market Is This Anyway?, by Gene Noser, first published in Institutional Investor
As a long-time veteran
of the securities industry, and as co-founder of a brokerage and trade
cost analytics firm with a 35-year history, I have been party to many of
the changes that technology has brought to the equity marketplace,
mainly for the better. While technology has no doubt improved the
efficiency of our business, the recent rise of High Frequency Trading
(HFT) threatens to ruin the capital formation system that has served
investors of all sizes so well.
Prior to the proliferation of
HFT, both retail and institutional investors came together to seek
profit as owners of a company, and as a result helped support crucial
capital raising and secondary market functions for American business
owners. But seemingly what we have now is a major portion of market
participants – HFTs – who are unregulated, often undercapitalized, and
who provide no redeeming social function. As I see it, they exist to
extract value from real investors one fraction of a penny at a time,
over and over again.
While our firm’s ability to embrace
technological change has served us well, I must draw the line with
HFT. At the risk of sounding alarmist, the May 6th “flash crash” and
subsequent trading halts in individual securities were the proverbial
canary in the coal mine. If regulators do nothing, our country risks
significant damage to our lauded capital markets system, and
subsequently our national security. Should financial terrorists fail to
honor trades, they would overwhelm undercapitalized clearing firms that
some HFTs use. In minutes, numerous trades would have the potential of
failing to clear, and our system would risk a disaster that makes the
fall of 2008 look like a cakewalk.
HFTs claim that they provide
necessary liquidity when trading. While this may seem true, the
differences in the responsibilities between HFTs and registered market
makers are where the dangers lie. Registered market makers,
increasingly a dying breed, have strict capital requirements and three
main responsibilities to the investing public: 1) Make an orderly
market when imbalances between buyers and sellers occur, 2) Bring two
customers together to facilitate trades, and 3) Act as an agent
representing customers. Many of them failed to do so during the crash
of 1987, with dramatic consequences. Similarly, many HFTs pulled their
bids during the “flash crash” of so they would not be supporting a
falling market. HFTs have none of the capital requirements, regulations
or responsibilities that registered market makers comply with, yet they
are endorsed by trading venues and ignored by regulators.
have exacerbated the problem. No longer non-profit institutions with a
public duty, exchanges and alternative trading venues realized that
speed and reduced latency created an informational advantage, even
within a time frame of microseconds, and struck deals with HFTs to sell
access to powerful bandwidth capabilities. These arrangements allowed
HFTs to scalp profits from real investors by discovering their trade
intentions and running in front of their orders. It’s akin to thousands
of people walking down the street with money in their pockets, and
pickpockets knowing which people have the most money and the precise
location of that wallet for the picking. In the past, when human
specialists and market makers were caught front-running orders, they
were banned from the industry. On the contrary the exchanges are now
encouraging a form of legalized front-running at investors’ expense.
more HFTs enter the market, speed and latency are like an arms race
with participants taxing capacity. Just recently it was reported that
one HFT purposely placed 5,000 bids per second in an attempt to jam and
slow down the NYSE’s quote system. This jamming technique gave the
culprit another trading advantage in picking off high bids and low
offers. Is this type of technological casino gaming good for the system
in the name of “liquidity?” Does this leave a positive impression with
investors? Given the “flash crash” as one of the main reasons for the
waning interest of individual investors in the stock market, the answer
In order for the market to return to its true function of
capital raising and away from a select few computer warriors, lawmakers
and regulators should consider the following changes:
HFTs to the same regulatory scrutiny as anyone making a two sided
market. Scrutinize their books, capital and technology and be satisfied
that they are not purposely or accidentally placing our system at risk.
should alter their profit model by charging all market participants on a
message traffic basis, not bandwidth, as at least 95 percent of all
messages going into the NYSE are cancels or cancel/replaces of orders
that will never be executed. This will eliminate frivolous posting of
orders which go unexecuted and only attempt to sniff out real orders to
enable technological front-running. Nobody will send 5,000 messages per
second down to any exchange in an attempt to derail a competitor if it
costs them real money.
3) Change the take and pay model for
buyers and sellers. Each party pays 5 cents per hundred shares traded
to the exchange as a fee. Anyone who cancels a bid or offer before there
is a trade pays 5 cents per hundred. Registered market makers pay zero,
unless they cancel a quote before a trade takes place.
to a Central Limit Order Book. The book must be protected up and down at
all prices. Only price and time get priority when trading. Solid bids
and offers will get priority, not phony ones that are cancelled in
microseconds. Price and time priority has worked for over two hundred
years, why are we trying to destroy it?
5) Examine and consider
raising the net capital requirements for clearing agents servicing HFTs.
Currently these firms allow many HFTs to use more leverage than most
investors. Should HFT-originated trades not clear and the system go
awry, these firms could go bankrupt in seconds and set off yet another
dangerous chain reaction. If HFTs register as a market–maker, they
benefit from the same margin requirements as other market makers, but
absent those market maker duties. HFT’s should post the same margin as
any other public market participants – 50 percent.
Washington and our legislators must act quickly before the next canary dies in the coal mine.
Gene Noser is the co-founder of New York-based agency brokerage Abel/Noser Corp. that has provided institutional trade execution and trade cost analysis since 1975.