Should high-speed trading be regulated?

Business Times - 29 Jul 2009

Hock Lock Siew

By R SIVANITHY

WHEN a US federal prosecutor was framing charges against an ex-Goldman Sachs employee for stealing some of the broker's secret computer codes earlier this month, the prosecutor said that in the wrong hands these codes could 'manipulate markets in unfair ways'.

Coming from someone with regulatory powers, this can't be good for public relations because if you think about it, the corollary is that in the right hands, the codes can lead to manipulation in fair ways.

No doubt the statement was inadvertent, a simple Freudian slip. But it has nonetheless raised the profile of high-speed computer trading in markets everywhere - and with it, issues regarding fairness as far as small traders are concerned.

The most important question as far as the public is concerned is this: should high-speed/frequency computer trading be regulated?

The answer depends on who you ask. Brokers and institutions who use these tools and spend millions developing faster and more sophisticated computers would of course say no, and for all we know, the same might apply to profit-driven exchanges because enhanced liquidity and volatility mean increased profits. What's more, the numbers can be huge - recent US reports say that high-frequency computer trading has been instrumental in pushing average daily volume on the New York Stock Exchange 164 per cent up since 2005.

But in the US at least, there is a growing lobby against lightning-fast trading on the grounds that it is unfair and possibly to the detriment of investors as a whole. And if the lobby grows, then regulation might well be forthcoming.

For example, US Senator Charles Schumer, chairman of the Senate rules and administration committee, this week asked the Securities and Exchange Commission to prohibit a technique known as 'flash orders' that gives big players an unfair advantage over small investors because it allows some of these big players the chance to peek at large orders a few milliseconds before the rest of the market, thus enabling front-running.

In this sub-category then, high-speed trading is nothing more than high-speed front-running (note that we're speaking of milliseconds here).

There are, however, several other sub-categories which US institutional agency broker Themis Trading described recently as 'toxic' for markets in a recent white paper (Toxic Equity Trading Order Flow on Wall Street - the real force behind the explosion in volume and volatility).

In it, the authors describe various high-speed computerised approaches to making money that are clearly not available to small investors.

For example, Automated Market Makers (AMMs) ostensibly run trading programs that provide liquidity to exchanges by supplying constant 'buy' and 'sell' quotes. But AMMs also have the ability to 'ping' stocks to identify reserve book orders. In pinging, the AMM issues an order ultra fast and, if nothing happens, cancels it. But if the order is filled, it learns valuable hidden information that it can exploit, such as the maximum amount that another algorithm is prepared to pay for an order. Once this can be determined via high-speed trial and error entry and withdrawal of orders, the AMM can then profit by buying lower and selling to the buyer at the buyer's maximum price.

In addition, there's program trading, liquidity rebate trading (a strategy to capitalise on rebates offered by exchanges in return for providing liquidity) and predatory algorithmic trading, which are other high-speed techniques that basically place retail players at a disadvantage and, as the writers conclude, impose a 'stealth tax on retail and institutional investors' because 'toxic trading of this sort takes money away from real investors and gives it to the high-frequency trader who has the best computer'.

Themis concludes that 'exchanges, ECNs (electronic communications networks) and high frequency traders are slowly bleeding investors, causing their transaction costs to rise - and investors don't even know it'.

How to curb the spread of such techniques and perhaps help level the playing field? One suggested means is to make all orders valid for at least one second, which would eliminate pinging and force high-frequency traders to expose themselves. Another is to impose a 2 per cent limit on program trading. With these two curbs in place, it is estimated that half the volume on exchanges will disappear.

You'd have to wonder though - will for-profit exchanges really take the steps needed to level the playing field if it could lead to reduced volume and, by extension, profits?