The Gateway to Algorithmic and Automated Trading

Fair Play

Published in Automated Trader Magazine Issue 35 Winter 2015

Major trading venues have historically championed the idea of a level playing field, but critics say the pitch can be decidedly uneven these days. Adam Cox reports on an intensifying debate over whether markets are indeed fair, and what that debate could lead to.

Eric Hunsader, Founder, Nanex

All may be fair in love and war, but how about the markets? In a world dominated by ultra-low latency technology, the spotlight on the industry - in terms of fairness - has never been brighter. Angry investors, lawsuits, media attention, calls for regulatory action, grandstanding by officials... rarely will a day go by when someone is not questioning whether the markets are fair and what is to be done about it.

The question itself is not so simple. There are myriad differences in regulations, either in terms of asset classes or geographies, and there are complex market practices and even more complex technologies that all need to be dissected in order to take a view. Most questions of fairness come down to who can see what data when. But they also can concern market features such as order types and trading rebates that, critics allege, benefit some sectors of the market more than others.

As each cry of 'Unfair!' has grown louder, there appears to be momentum behind the would-be reformers, a small but prominent group of market practitioners and technologists who want to put pressure on market venues to alter their rules and foster more transparency.

Meanwhile, regulators have been talking a tougher game and levying more fines (although it is worth noting that a record $16 million fine recently slapped on HFT group Latour was not about fairness but rather concerned the firm's risk procedures). Whether all this will result in meaningful changes that significantly affect different groups of market participants is not entirely clear. What is clear is that the pressure shows no sign of dissipating.


One of those calling for reform is Eric Hunsader, a developer who founded data technology group Nanex. He has little trouble describing what he sees as the root of the problem, at least as far as US equity trading is concerned.

"The reality that is the core of all the market structure issues that we have is that there are two things that price the same stocks," Hunsader told Automated Trader.

One of those is the Securities Information Processor (SIP), which under Regulation National Market System (Reg NMS) is meant to receive data from all the exchanges in the United States and calculate the National Best Bid and Offer (NBBO) on a given share. The other is the direct data feed an exchange will sell to clients.

Hunsader said that when Reg NMS was passed in 2006, the idea was that direct feeds would provide additional information. "It was never thought that they would actually supply it faster. In fact, a lot of the language back then

in 2006 was that information travels instantly so there really wasn't any awareness that a tiny speed difference would cause the damage it has caused. But they were very clear in saying you can't give this core information faster to your direct feed customers than you can to the SIP."

Hunsader has established a reputation as one of the most vocal critics of HFT practices. Soon after the Flash Crash of May 2010, he began publishing analysis of the causes, ultimately pointing the finger at high frequency trading and differing sharply with the conclusions of an official SEC report. Along the way, he identified an issue that became crucial in a landmark fine of the New York Stock Exchange and one which is central to the current lawsuit.

What Hunsader worked out was that it was possible for firms - at least those firms that were willing to pony up
the money in terms of direct feeds, hardware and software - to calculate the NBBO faster than the SIP.

Hunsader is dismissive of arguments that exchanges are not providing any data faster to some parts of the market. "Just plain physics proves that's a lie," he said, with characteristic bluntness.

Last year he met a man named Michael Lewis - not the author of the book Flash Boys, but a lawyer by the same name who was interested in bringing a class action lawsuit over alleged unfair trading practices.

Hunsader spent time with Lewis (the lawyer) to explain how markets worked and what data could show. On May 30 of this year, not long after the book by Lewis (the author) began to dominate the headlines, the attorney filed a suit on behalf of Harold R. Lanier and "all others similarly situated" against NASDAQ, the NYSE, and 11 other exchanges.

"This case is about broken promises," the suit said. It alleges that the exchanges promised to be fair by providing a market data service in a non-discriminatory manner and by providing "valid" data that was accurate and not stale, but that they did not live up to either promise.

Lewis had little chance to go after individual traders because he would have needed consolidated audit trail data, which wasn't possible, and he would need to prove specific damages. Going after the exchanges was equally problematic because of their status as self-regulatory organisations (SROs).

So the lawsuit is based on the sale of two different items that are each called real time. "By its very definition there can only be one real time anything. There's precedent here because the New York Stock Exchange was fined by the SEC for supplying direct feeds with data faster than the SIP," Hunsader said.

Lance Zinman, Partner, Katten Muchin Rosenman

Lance Zinman, a partner at Katten Muchin Rosenman LLP, who represents many low latency firms, said exchanges have always had an interest in ensuring that trading on their venues was orderly and not manipulative.

"The desire of the exchanges to implement order and regulation has not changed since their inception. It's become more complicated given the introduction of electronic trading and the subsequent increase in speed of trading and the volume of orders," he said. "But that desire, I don't think has ever changed. Now they just have more specific rules around it. And as the industry has evolved they have more clarity around what disruptive or manipulative practices would look like."

Ironically, Hunsader said exchange officials tend to be encouraging of his work and say how much they enjoy reading what he publishes.

"It's almost like all the exchanges kind of wish that there was a parent to say, 'This is how you have to do it.' Because no exchange wants to unilaterally do the right thing because they'll get killed in the market place," he said.

Another element of irony: it could be in the exchanges' interest to adopt Hunsader's prescriptions.

"What I'm talking and preaching about is going to save them a lot of money because it will greatly simplify (their business) when they don't have to compete with this other exchange if it decides to break the rule with their direct feed product," he said. "It really simplifies things for them so I think they see it as a benefit if all the exchanges have to do it. But nobody likes the problems pointed out."

Hunsader believes the law as it stands should be enough to make the market fairer, but it is neither being followed nor enforced.

"I say, if the industry wants to change the rule and say that direct feeds can be faster, I'm not going to be one who says no. I'm going to be one to point out all the reasons why we didn't do that back in 2006," he said. "But if something is a law that means that anybody who wants to build a business around that is either going to follow the law or they're going to take what's called in the industry regulatory risk. I don't think regulatory risk should ever be part of the business equation."

Still, Hunsader does not expect change from the regulator anytime soon, although a successful lawsuit could alter that scenario.

"Transparency is the only way to instill confidence," he said. "If there are manipulation laws, they've got to apply equally to everybody."


Transparency is the operative word as well for Mark Spanbroek, vice chairman of the FIA European Principal Traders Association. In fact, he reckons the equity market is much more advanced in that respect than other asset classes.

"This is a market which has become very transparent over the last 20 years," he said, referring to equity markets. "There's a lot of competition around, which is good. And the FX market and the fixed income markets are the more opaque markets, more closed, more private."

Spanbroek said the issue of market opacity for FX and fixed income trading was seen on private platforms but
did not extend to exchanges that list currency- and debt-based products.

More to the point, the flows in these markets are interconnected with other markets. "These money flows are actually world-wide monetary flows," he said, noting for instance that liquidity from forex markets can be invested in bond markets and the other way around.

"These markets are all combined. We need to adapt the regulation towards it."

The EPTA executive is clear on what transparency means. "For us that means everyone can and will know exactly what an exchange, a platform, a venue actually puts out, in what sequence, and at what latency their data transmission works," he said. "There cannot be a private network coming from anyone towards a certain individual or trading group. That cannot be on latency, and that certainly cannot be on deals, like incentive schemes. There's no way that should be allowed and no way we as EPTA will fall for that trap."

ParFX is one FX venue that has tried to change the nature of currency trading by pioneering features such as a randomised pause of 20-80 milliseconds on all order submissions, amendments and cancellations. It also distributes market data to all participants in parallel. ParFX said its efforts address some of the root causes of disruptive behavior that have distorted the market.

Roger Rutherford, Chief Operating Officer, ParFX

Roger Rutherford, chief operating officer at ParFX, said high-frequency traders have actually played an important role in boosting liquidity and lowering trading costs in recent years.

"It is true that disorderly trading strategies and behaviour became prevalent on some platforms, which upset the balance of the marketplace. However, high frequency and algorithmic trading is not bad in itself - it is the logical and natural evolution of electronic trading," Rutherford said.

"Rather, it is the intent and behaviour behind certain trading strategies that needs to be questioned. Such behaviour created many negative knock-on effects, such as the mass internalisation of FX flow at the largest banks, and frustration amongst smaller firms that were consistently being 'pipped' by latency- based trading strategies."

Rutherford also said transparency was key in terms of fees.

"We are also 100% transparent with our fees and trading costs, which are the same for everybody. ParFX does not allow the largest trading firms with the deepest pockets to negotiate special deals - a prevalent factor that continues to contribute to an unfair trading environment for those that don't operate with the same financial resources," he said.


Spanbroek said one of the changes exchanges have made is how to deal with latency around an order fill. As an example, he cites Eurex latency between a fill message and the actual data feed.

"After a dialogue with the exchange and regulators, they've changed that in such a way that the fill doesn't always come to the particular member first, let's say in 90% of the cases, before the data feed will show this," he said.

Spanbroek said each exchange needs to have the ability to send a message to the member making the trade first for risk management reasons, and he is wary of regulation that could change that situation.

"We think it's very good that Eurex has made this a level playing field. Other exchanges may be acting in a different way, but certainly there's a discrepancy between sending it through the data feed to the worldwide members or sending it first to the member. This opens up activity not just between our members but the whole world."

He said that if a firm knew it could receive a message microseconds ahead of everyone else, it would fill up the exchange with orders or other messages. "That doesn't always have to be a situation of market abuse, but it can potentially lead to one and exchanges and platforms can check if the same party trades on this and can look into a potential market abuse case."

He said FIA EPTA will ask surveillance at exchanges to look at whether so- called liquidity providers are engaged in that kind of activity. "We need to step up that surveillance, which I know now most exchanges are doing."

One issue that the association is cognisant of is the distinction between passive and aggressive providers of liquidity. "That's an issue we will discuss with the regulators," he said. "It (the message proliferation) comes nine out of 10 times from the pure aggressive players. That is a given by the nature of their business but we can also make that more transparent."

And Spanbroek wants to go beyond exchange surveillance. "I think the regulator needs to take a proper look," he said. "If someone is able to receive a message one microsecond before someone else for its internal risk adjustment, is that called market abuse or is it in line with MiFID regulation around risk management? I think the regulator needs to speak up about that."

Mark Spanbroek, Vice Chairman, FIA European Principal Traders Association

He said FIA EPTA strongly supports transparency into the latency of data feeds and disclosures on how data feeds are being utilised.

Dialogue between exchanges, the market and regulators can make a difference. Often, said Spanbroek, politicians, unlike regulators, don't recognise the issues. "We need to take the lessons we have learned from the equity world and apply them to other asset classes. Politicians do not seem to acknowledge this. What we have learned from HFT and the equity world we recommend using to foster similar transparency in markets like FX and bonds. In particular, we need to educate politicians concerning how it works," he said.

Germany has been one of the places where politics has led to change. One avenue it has pursued in seeking to regulate HFT is to require those firms that meet its definition to register. "A lot of big proprietary trading firms that trade in multiple asset classes are trading on Eurex so some of those traders have been required to register in Europe," Katten's Zinman said.

That in itself is not so onerous, particularly if firms can "passport" their registration by registering with, say, the UK's Financial Conduct Authority. But in some cases, smaller firms have had to locate people in Germany to comply with the registration.

"A lot of the big firms already have offices in Europe but the mid-to smaller size firms may not, and in order to comply with the registration requirements they have had to put some people on the ground," Zinman said.

That creates both extra costs and regulatory issues. "Once you put people on the ground you get into a tax analysis. For example, I've got people over in Europe and I've got people in the US. Now things become more complicated and I may have to start allocating taxes between the various countries."

Zinman said he didn't think the regulation changes the nature of trading significantly but it did represent a material cost.

"So to that extent it could have an impact on Eurex because if, hypothetically, you were trading on Eurex and you decided the cost was prohibitive to your profit potential, you may either decide not to trade Eurex any more or in Germany. Or you may alter the way you trade so that you are no longer considered a high frequency trader under German law," he said.

"I don't think it fundamentally changes the fairness of their market versus other markets."

Many in the market have argued that venues and participants, rather than politicians and regulators, should be driving whatever changes are deemed necessary.

Rutherford puts his firm, ParFX, as a prime example of the value of market- led change.

"Financial markets are often good at identifying and solving their own issues, and this is equally the case in FX. ParFX is an example of the industry coming to together to collaborate and improve the market environment, while taking steps to address disruptive and disorderly behavior," he said.


Zinman said Flash Boys had clearly brought a lot of attention to the subject of market fairness. "But in my mind, the regulatory tools have already been in place, especially since Dodd-Frank, so I don't think it's a different issue. It's just an issue that is drawing a lot more attention now."

So, can the market expect more draconian rules?

"It's definitely something that people are worried about," Zinman said. "As to how, 'draconian' those measures could be? I think the idea that at some point there would be a registration category wouldn't surprise people."

He added that there is a lot of talk about this on the equities side, and whether everybody's going to be registered as
a broker-dealer to the extent they are trading in this manner or how closely they resemble market-makers.

Beyond that, the idea of minimum resting times looks unlikely at the moment, although he said even
though he believes that they are not warranted, given all of the attention and the politically charged nature of the discussion, "anything's possible".


A core argument in the fairness debate has been about technology and how firms can essentially buy an unfair advantage. Many in the market have said that HFT is a fairly blunt method, which is not so much about being sophisticated but about using brute technological force.

In that respect, some say the technological trend could help level the playing field since costs for low latency trading are coming down.

Roji Oommen, Managing Director Financial Services, CenturyLink

"Broadly speaking we would say that the path the technology has taken has been about dramatically reducing barriers," said Roji Oommen, managing director of financial services at CenturyLink. In terms of electronic trading, the cost to deploy applications from an infrastructure perspective has plummeted, he said.

One thing that is driving costs lower is the ability for firms to eliminate capex spending and just rent the server power they need at the times they need it. Or, if they want to own their own hardware, they can defray costs by leasing it out at times.

"The cost of entry at least from a technology perspective is not a major barrier in these markets," Oommen said. "It is true that if you're going to execute a pure speed-based trading strategy, there are things like microwave services at the cutting edge which are relatively expensive. But the firms that play in that space are relatively few, even though the costs for those services have come down relatively dramatically too."

One part of CenturyLink's business is providing colocation services, a sector of the industry that has been in hot demand in recent years due to both falling latency and growing electronification.

Oommen said he wouldn't want to comment on regulatory issues, adding that the company has clients on both sides of the issue. He did note that IEX, the new exchange formed by Brad Katsuyama of Flash Boys, was one of CenturyLink's customers. IEX, whose infrastructure is hosted at CenturyLink's data centres, has made equal treatment a core part of its business model.

Dave Snowdon, founder and co-CTO of Metamako, goes further and argues that technology is ultimately the solution to the issues the market faces. "There is no single, easy solution to creating truly fair exchanges," he said. "There are several things that can and need to be done and in virtually every case technology is the answer, not the problem."

Snowdon said exchanges were hugely complex systems, even before multi- jurisdictional compliance and regulations such as RegNMS are taken into consideration. "Creating a level playing field and increasing transparency requires understanding and predictability of each of the systems that each message goes through," he said.

Snowdon also noted the equality gained from co-location. "Achieving determinism is an enormous challenge: there are many sources of variation, like uneven load on order gateways, which can give a huge advantage to some participants."

While having legacy applications within the technology stack is something that needs to be addressed over time, and clever participants may still derive advantages until non-determinism is addressed, Snowdon said the intelligent use of technology is the only effective route to a level playing field, and the equality that regulators are trying so hard to achieve.