[Infowarrior] - Wharton: time to crack down on high frequency trading?

[Richard Forno]

c/o DOD (no, not that one.  ---rick)

Begin forwarded message:

> http://knowledge.wharton.upenn.edu/article.cfm?articleid=3170
> 
> High-speed Trading: Is It Time to Apply the Brakes?
> Published: January 16, 2013 in Knowledge at Wharton
> 
> How fast is high-frequency stock trading? In the time it takes to read this
> sentence, tens of thousands of high-speed, computer-automated transactions
> can occur. Winning traders edge out rivals by intervals measured in
> nanoseconds. Fans of the practice say that high-frequency traders add
> crucial liquidity to the stock market. Critics dispute that claim and
> highlight, instead, lurking perils for the global financial system.
> 
> High-frequency traders "can execute trades more quickly at better prices,
> but many investors worry that this has introduced additional fragility to
> the system," says Wharton finance professor Pavel Savor. "It's also possible
> that high-frequency traders earn their profits at the expense of long-term
> investors."
> 
> A series of costly glitches has added fuel to the arguments of those who
> oppose the practice, in addition to inviting renewed scrutiny by regulators.
> Last August, for example, faulty software used by high-frequency trading
> firm Knight Capital Group generated $461 million in losses, nearly causing
> the firm to collapse. Shortly afterward, Knight was sold to Getco Holding,
> another high-frequency firm, for $1.4 billion. The high price Getco paid for
> Knight sheds light on the value of high-frequency trading outfits, even
> those in difficulty. The stakes are high: For instance, Tactical Fund -- the
> high-frequency trading unit of investment firm Citadel -- recorded a 25.7%
> net return in 2012, The New York Times reported.
> 
> Despite the controversy surrounding it, high-speed trading now dominates the
> mainstream with enormous sums at stake. Indeed, high-frequency trades
> account for the vast majority of volume on major stock exchanges. On NASDAQ
> alone, daily trading volume approached $50 billion in early January. Three
> other leading exchanges -- NYSE/Euronext, BATS and Direct Edge -- as well as
> "dark pools" run by banks and private equity firms outside public view trade
> millions more shares every day. The flood of high-frequency bids tests
> markets in search of price points. When not filled, the bids are cancelled
> instantly, adding market noise for everybody else.
> 
> The speediest traders exploit momentary "latency" gaps between nearly
> instantaneous access to market orders and when those orders become widely
> known. In those minute gaps, high-speed traders post orders for stock in
> front of other inbound orders. Hundredths of a second decide outcomes. In
> fact, shortening the lengths of fiber optic cables that carry orders at the
> speed of light can make the difference between grasping market opportunities
> -- or missing them.
> 
> Humans cannot possibly trade at this pace; instead, the trades are
> accomplished by computer algorithms geared to split-second investment
> decisions. As one visible sign of the rapid and thorough takeover by
> computers, traders buying and selling shares on the fabled floor of the New
> York Stock Exchange numbered 3,000 in 2007. According to the New York Post,
> today their population has dwindled to 300, with many serving as caretakers
> to their digital heirs. Some observers predict extinction for floor traders
> once antitrust officials approve the pending union between the NYSE and the
> highly automated, Atlanta-based Intercontinental Exchange (ICE), which was
> launched in 2000.
> 
> High-frequency traders collect more than capital gains on trades. Successful
> bids increase market liquidity that attracts listed companies and investors
> to exchanges. To incentivize bidders, exchanges pay rebates on successful
> bids. In this "maker-taker" arrangement, high-frequency traderscan buy and
> sell a share of stock at the same price and still make profits by snaring
> rebates designed to lure traditional investors. Once shares move in less
> than the blink of an eye, high-frequency traders sell them to investors
> lined up to buy.
> 
> "Clearly, high-frequency trading has enhanced liquidity," says Savor. While
> rigorous academic research on the practice is still in early stages, most
> studies suggest high-speed trading helps investors trade more quickly and at
> lower cost. However, visible benefits, Savor notes, do not rule out a
> paradox. It appears that high-frequency traders who enhance liquidity at
> times may, in fact, hurt liquidity when markets shudder and the traders
> instantaneously pull back. Legions of resilient 20th Century floor traders
> once stood their ground in up and down markets alike, usually to their
> economic benefit. Skittish high-frequency traders in duress simply unplug
> their computers.
> 
> Algorithms Gone Wild
> 
> Sometimes, however, they don't unplug them soon enough -- as Knight Capital
> illustrated when its algorithms began issuing orders at a relentless pace
> that no one could stop until its computers were shut down. Fears about
> potential catastrophes brought on by computer-generated errors were
> reinforced again earlier this month, when BATS Global Markets, the
> fourth-largest exchange in the U.S., admitted that a glitch in its system
> triggered 440,000 transactions since 2008 at prices lower than the national
> best bid and offer (NBBO). Despite the fact that investors lost money, BATS
> insisted that the mispriced transactions represented an infinitesimal
> fraction of total BATS trading volume.
> 
> Other events also have cast doubt on the reliability of high-frequency
> trading, starting with the 1987 stock market crash when computer-driven
> trading -- then only in its infancy by today's standards -- caused record
> losses. More recently, the May 6, 2010, "Flash Crash" made high-frequency
> trading a headline -- and a renewed target for critics and regulators. The
> market that day skidded 1,000 points and recovered in a matter of minutes, a
> fluctuation largely blamed on jumpy computer algorithms.
> 
> "The story of the Flash Crash is that the market failed that day," write
> stockbrokers Joe Saluzzi and Sal Arnuk in their book, Broken Markets.
> High-frequency trading "was exposed as a conflicted and rigged game in which
> only the connected insiders stood a chance.... When one participant accounts
> for so much volume and has eclipsed so many other participants, and its
> trading styles and horizons prevail, the ecosystem is in disequilibrium. One
> of its more predatory species, such as a shark, has become overwhelmingly
> dominant. And it is unsustainable."
> 
> Market participants who think that high-frequency trading keeps markets
> liquid at all times labor under a dangerous misconception, the authors
> argue. "The slightest hiccup and our new [high-frequency trading] market
> makers go running for cover," Arnuk and Saluzzi note. "They are not there to
> profit from the smooth flow of capital. They are there to profit by taking
> advantage of retail and institutional investors and by scalping wealth from
> IRAs, 401ks, and government and corporate pension funds."
> 
> In calmer times, the authors add, high-frequency trading firms hold an
> insurmountable edge: They can see the future. "They know what the quote of
> any given stock will be microseconds before those looking at the SIP [the
> system that disseminates quotes to the public]." No wonder firms with deep
> pockets pay dearly to locate their servers as close to exchanges as
> possible.
> 
> So far, Arnuk notes, investors have been spared the worst effects of
> distortions that stem from high-frequency trading. But what if algorithms
> run amok when the marketplace is especially fragile -- say, when a European
> government defaults?
> 
> Others say there may be no reversing course. "Technology is here to stay,"
> Lawrence Leibowitz, NYSE/Euronext chief operating officer, told a Yahoo
> interviewer. "The real question is, how do we regulate it and [monitor] it
> in a way that gives people the confidence that it is fair and that they have
> a chance?"
> 
> Applying the Brakes
> 
> Proposals abound for regulating high-frequency trades. According to Wharton
> finance professor and trading desk veteran Krista Schwarz, all aim at
> applying the brakes: requiring high-frequency traders to honor bids for a
> half a second before withdrawing them; imposing fees when ratios of bids
> transacted exceed a ratio of bids withdrawn; introducing order cancellation
> fees; limiting the number of orders per second; levying taxes for intraday
> transactions; imposing size limits; or expanding use of circuit breakers
> similar to those that NYSE/Euronext has introduced.
> 
> New rules could erase speed differentials between distribution of orders to
> public and private data feeds. Others might eliminate "phantom indexes" that
> represent only a quarter of trades that occur on exchanges. Comprehensive
> real-time identification would fetch trading data from exchanges and dark
> pools. And some critics have prioritized putting an end to the "maker-taker"
> model that rewards high-frequency trades with rebates.
> 
> "What you are looking for is to prevent the most extreme case scenario, a
> black swan," says Schwarz. "If you don't let prices move beyond certain
> points or percentages in certain periods of time, it at least slows things
> down and gives the market a chance to reassess." Unfairness to traders who
> can't compete with high-frequency counterparts is one issue; risk to the
> financial system quite another, many analysts contend.
> 
> Some argue that calls for regulation ignore the fact that markets have never
> been level playing fields. Professionals have always enjoyed advantages, and
> some professionals more so than others. One former NYSE specialist who spent
> decades on the stock exchange floor and has no stake today in high-frequency
> trading says that he wouldn't turn the clock back. He recalls the open
> outcry auctions in his day, when floor specialists had a timing and
> information advantage over practically everyone else. "There is a desire by
> investors to slow the process down again to make it fairer. But the real
> question is, fairer to whom? The slow-witted and the lazy? People who prefer
> rotary phones?"
> 
> "Over and above clamping down on market manipulation, regulating
> high-frequency trading is misguided," says Larry Tabb, CEO of the Tabb
> Group, a research and advisory firm focused on capital markets. "The problem
> is the speed of light. People who are [physically] closer to the markets
> will always have a speed-of-light advantage"because their data has less
> distance to travel.
> 
> High-frequency trading might appear to pose threats on the horizon, notes
> Tabb, but hasty regulation is all but certain to trigger unintended
> consequences. "It could totally destroy the market," he says. If rules lock
> a high-frequency investor into a bid of $102 for even half a second when the
> market value is $101, other investors could swoop in at $101 and make a
> dollar a share on the incorrect price. This will create incentives not to
> quote or provide liquidity, making it harder and much more expensive to
> invest.
> 
> And while the specter of systemic risk looms large in many arguments against
> high-frequency trading, those in favor of the practice note that although
> Knight Capital blew up and the Flash Crash shook confidence, the market
> still rebounded on its own. It is easy to overestimate the true influence of
> high-frequency traders, says Savor. "They account for a lot of trading
> volume, but some of it is just trading with each other. That's a lot of
> churn, but I'm not sure it impacts markets dramatically."
> 
> If any reform is to come from the U.S. Commodity Futures Trading Commission
> (CFTC), which shares with the SEC regulatory oversight of high-frequency
> trading, expect to wait. CFTC commissioner Scott D. O'Malia, who heads the
> regulator's technology task force, says action hinges on defining
> high-frequency trading itself. Does it mean all automated trading, trading
> subject to a certain threshold or some other measure? "There is currently no
> consensus among market participants as to the definition of high-frequency
> trading," O'Malia said in May 2012.
> 
> While the debate simmers, high-frequency traders are enlisting influential
> allies in Washington. Republican members of Congress Jeb Hensarling of Texas
> and Spencer Bachus of Alabama are advocating a slow approach to any
> regulatory initiatives. In letters to the SEC and the House Financial
> Services Committee, both congressmen warned not to "shoot the computers
> first and ask questions later."
> 
> 


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Just because i'm near the punchbowl doesn't mean I'm also drinking from it.