The SEC has released its Preliminary Findings Regarding the Market Events of May 6, 2010, which find nothing, and just bring the promise of further investigations. The to-date proposed solution to the problem is laughable - more curbs, which do nothing to address the underlying issues at hand, which are that the modern version of market makers, HFT algos, pull liquidity away on a whim, and which can destabilize the market in an instant once "momentum ignition" strategies take over. As we have speculated, the SEC will find nothing material until such time as the next flash crash wipes out not 10% but puts the market into indefinite hibernation. One thing the report does do is provide an extensive analysis of High Frequency Traders, a concept that was barely known as recently as a year ago.
High Frequency Traders
Highly automated trading systems have helped enable a business model for a new type of professional liquidity provider that is distinct from the more traditional exchange specialist and over-the-counter (“OTC”) market maker. In particular, proprietary traders now use high speed systems by submitting large numbers of orders that can result in more than 1 million trades per day by a single firm. These proprietary traders often are labeled as engaging in high-frequency trading (“HFT”), though the term does not have a settled definition and may encompass a variety of strategies in addition to passive market making.
HFT traders can be organized in a variety of ways, including as a proprietary trading firm (which may or may not be a registered broker-dealer and member of FINRA), as the proprietary trading desk of a multi-service broker-dealer, or as a hedge fund (all of which are referred to hereinafter collectively as a “proprietary firm”). Other characteristics often attributed to proprietary firms engaged in HFT are: (1) the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders; (2) use of co-location services and individual data feeds offered by exchanges and others to minimize network and other types of latencies; (3) very short time-frames for establishing and liquidating positions; (4) the submission of numerous orders that are cancelled shortly after submission; and (5) ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions over-night). Given the competitive pressures to maximize their speed of trading, HFT firms typically will attempt to streamline the code for their trading algorithms. However, every check and filter in that code reduces its speed, creating a tension.
HFT is one of the most significant market structure developments in recent years. Estimates of HFT volume in the equity markets vary widely, though they often are 50 percent of total volume or higher. By any measure, HFT is a dominant component of the current market structure and is likely to affect nearly all aspects of its performance. In addition, though the term HFT implies a large volume of trades, some of the concerns that have been raised about particular strategies used by proprietary firms do not necessarily involve a large number of trades. Indeed, any particular proprietary firm may simultaneously be employing many different strategies, some of which generate a large number of trades and some that do not. Conceivably, some of these strategies – for example, if they dampen short-term volatility or promote efficient pricing by narrowing spreads – may benefit market quality and long-term investors and others could be harmful.
What is hilarious is that the SEC, as demonstrated by footnote 88, gets its information from Jonathan Spicer of Reuters and Scott Patterson of the WSJ: See, e.g., Jonathan Spicer and Herbert Lash, Who’s Afraid of High-Frequency Trading?, Reuters.com, December 2, 2009 (available at http://www.reuters.com/article/idUSN173583920091202) (“High-frequency trading now accounts for 60 percent of total U.S. equity volume, and is spreading overseas and into other markets.”); Scott Patterson and Geoffrey Rogow, What’s Behind High-Frequency Trading, Wall Street Journal, August 1, 2009 (“High frequency trading now accounts for more than half of all stock-trading volume in the U.S.”).
One thing that there is no mention of anywhere in the report, is the NYSE contraption known as Supplementary Liquidity Provider, a program created to give Goldman dominance over the DMM-parallel liquidity rebate system at the NYSE. One would think that the SEC would be aware of this program that was supposed to expire in early 2009, yet continues to be extended and provides Goldman and Getco with, arguably, unprecedented forward-looking information on order flow.