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Life in the slow lane

Published in Automated Trader Magazine Issue 30 Q3 2013

The foreign exchange market is grappling with the question of speed. Eva Szalay looks at the implications of efforts to make currency markets slower.

Svante Hedin

Svante Hedin, global head of FX automated trading strategies, JP Morgan

"Having to keep up with the agility of ultra-high frequency traders is a real barrier to entry and a very costly exercise,"

Efforts to slow interbank currency trading down could expose players that rely purely on speed advantages gained by superior technology and simple arbitrage strategies. After years of single-minded focus on speed, the new question institutional currency traders will have to ask is this: will my strategy still make money if my speed advantage is taken away?

The theory is being tested on a recently launched FX trading platform, ParFX which employs speed bumps for trading to level the playing field among market participants. The 20-80 millisecond speed delays are randomly applied to orders arriving to the platform's matching engine instead of the usual first-in-first-matched rule applied on other institutional platforms.

The move comes after years of growing discontent among large banks that control the majority of flows in currency markets. In the past few years, the face of the interdealer market has changed considerably due to some non-bank players engaging in aggressive latency arbitrage strategies, pushing up the cost of investment and resources required to keep up with the increasingly faster market.

Nimble high frequency trading firms often rely on their superior technology and connections to trading platforms on both the execution and the data side to profit from other traders' bets - a trading profile called latency arbitrage.

ParFX portrays its approach as one that helps the little guy as well as the big guy.

"The victims of the status quo are not a narrow cluster of banks and wealthy institutions; it impacts regular people - those invested in pension funds," said Campbell Adams, a London-based consultant who initiated the ParFX platform under the working title 'Pure FX' some three years ago. Subsequently, Adams and Tradition secured the support of 11 founder banks.

"There is a need to fundamentally reassess the way the market is going and develop a way of trading that is more socially responsible and socially valid," Adams added.

Adams said internal studies showed that ParFX's randomised speed bumps and free data updates has already proven to be beneficial for participating banks, while other platforms are still operating on the first in first matched basis.

One such system is ICAP-owned EBS. The platform has been fighting discontent from core bank customers in the past two years. Gil Mendelzis, the chief executive of EBS, has revamped the way currencies are quoted on the system, only allowing quotes in the fifth decimal to be made in increments of five. That fifth decimal had made it easier for high frequency traders to make latency arbitrage trades.

Now EBS says it is in consultation with its clients about imposing speed bumps like ParFX, albeit on a much smaller scale. EBS suggested its latency floor could be a range between 3 milliseconds to 4 milliseconds. A decision is yet to be made on the exact delay. It is also unclear if EBS plans to batch incoming orders together and release them after the imposed delay, rather than applying randomised pauses to each order. EBS declined to comment.

"What's been happening in recent years is a blurring of the lines between dealer-to-dealer platforms and dealer-to-customer platforms. After EBS allowed buy-side customers such as hedge funds onto its platform banks have been torn between the desire to see those flows and their hatred of being picked off," said Fred Ponzo, managing partner at Greyspark, the financial consultancy.

"I think the proposal is an effort to try to give enough ground to the banks to keep them happy and to alleviate their main gripe, which is that customers are trading on the same platform as them," Ponzo added.

The predatory HFT play

Currency markets experience mini flash crashes every day due to the asymmetrical distribution of market-relevant information.

Ultra-fast traders have a very simple strategy: they flush out banks' positions by sending tiny orders into the market and cancelling them before the trade gets done. By doing this signalling, they gain information about where large orders are and exploit it by moving markets away from those levels and forcing other traders to execute their orders at artificial levels.

Foreign exchange traders call these events gapping. They occur when high frequency traders layer their books with bids and offers in small amounts to give an impression of liquidity in the market.

However, as soon as other players try to trade against those prices, the liquidity is pulled in within microseconds, preventing traders from executing their orders at the price they thought they were getting. Once the order is completed, the market returns to the real price or to where it had been before.

HFT firms in effect load their books up to gather market information while watching multiple market data feeds and reacting before traders can hit their prices to jump on tiny moves then cashing in. Decimal pricing was a crucial factor in gapping, as orders could be sliced at more price points within a pip.

But to do this, predatory HFTs need to be able to access data and send orders faster than anyone else. A study by Brian F. Mannix from George Washington University's Regulatory Studies Center says that racing the tape is possible because the technology used for disseminating market news and processing market orders is the same, making the two processes strongly coupled.

"The net effect can be destabilizing as trading programs attempt to outrun each other in the direction of any perceived trend, or else defensively withdraw, causing liquidity to evaporate," Mannix writes.

The use of speed bumps is aimed at eliminating the information asymmetries that arise purely from a speed advantage. By imposing a randomised auction process onto the orders, platforms allow a larger proportion of participants to absorb market data faster than the order execution process, in theory making price discovery more efficient because information is now more symmetrical.

"Because the efficient market hypothesis emphasizes the speed with which information is incorporated into prices, many people tend to confuse speed with economic efficiency, thinking that faster must always be better. This is nonsense, of course," writes Mannix.

"Real-world markets can always be made to operate a little faster, for a cost; but they can never be instantaneous. As the speed of trading approaches instantaneity, the cost will approach infinity."

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