Why is HFT on the Regulators' Agenda?
Regulatory changes on both sides of the Atlantic have altered the exchange-traded landscape, resulting in a substantial increase in the number and type of exchange-traded platforms. Most significantly, electronic trading has virtually replaced the traditional floor- and telephone-based trading. This, in turn, has revolutionized the technologies for generating, routing and executing orders. Accordingly, the speed, capacity and sophistication of the trading functions that are available to market participants have improved dramatically. As the SEC itself points out, this transformation can be seen very clearly by looking at trading of listed equities on the New York Stock Exchange (NYSE), which moved to electronic trading only in 2006. NYSE's average speed of execution for small, immediately executable (marketable) orders was 10.1 seconds in January 2005, compared to 0.7 seconds in October 2009; consolidated average daily share
volume in NYSE-listed stocks was 2.1 billion shares in 2005, compared to 5.9 billion shares in January through October 2009 (an increase of 181%); consolidated average daily trades in NYSE-listed stocks was 2.9 million trades in 2005, compared to 22.1 million trades in January through October 2009 (an increase of 662%); and consolidated average trade size in NYSE-listed stocks was 724 shares in 2005, compared to 268 shares in January through October 2009.
As a result of these fundamental changes to the markets, regulators, not surprisingly, are assessing whether market structure rules have kept pace with, among other things, changes in trading technology and practices. HFT is high on their agenda due to the high percentage of total trading volume comprised of HFT and the fact that a significant portion of HFT takes place through unregulated proprietary trading firms. Given the political and regulatory climate following the near collapse of the banking and financial system in 2008-2009, and the attendant desire to ensure regulators are better able to assess systemic risk in the future, it is no surprise that regulators want to understand HFT and assess what risks it may pose to the markets and whether there is a potential for HFT traders to gain unfair advantages over traditional long-term investors or undertake illegal or improper transactions without regulatory scrutiny.
U.S. Regulatory Initiatives
Among the SEC's initiatives are the creation of a large trader reporting system, a ban on "naked" market access, elimination of flash orders and changes to the operations of "dark" pools of undisplayed liquidity. In addition, the SEC recently adopted a price test for short sales that would prevent the execution of a short sale of a stock at the best bid when that stockhas experienced a greater than 10% decline from its previous closing price.
These initiatives coincide with the SEC's issuance of a "concept release" asking questions about a wide range of tools used by high frequency traders, including co-location arrangements, market data latencies and undisplayed liquidity. Recurring themes in the concept release include whether long-term investors are harmed by short-term trading strategies and whether such short-term strategies should be addressed by new rules.
Acknowledging that there is not one definition of HFT, the SEC is interested in better understanding whether specific strategies benefit or harm the market and the interests of long-term investors. Possible regulatory responses noted by the SEC for high frequency proprietary trading firms include:
- imposing a minimum duration (such as one second) before an order can be cancelled, whether across the board, in particular contexts or when used by particular types of traders;
- prohibiting or restricting the use of "pinging" orders (which are commonly used to assess undisplayed liquidity);
- requiring that some or all proprietary trading firms be subject to affirmative or negative trading obligations that are designed to promote market quality and prevent harmful conduct; and
- requiring all proprietary trading firms to register as broker-dealers and become members of the Financial Industry Regulatory Authority (FINRA) in order to subject their operations to full regulatory oversight.
More broadly, the SEC questions whether HFT poses risks to the integrity of the current equity market structure. The SEC asks whether the high speed and enormous message traffic of automated trading systems threaten the integrity of trading center operations. Finally, the SEC also questions whether firms engaged in similar strategies could generate significant simultaneous losses, placing such firms in financial distress, and potentially leading to large fluctuations in market prices.
With respect to dark pools and undisplayed liquidity, the SEC's review is focused on whether undisplayed liquidity has reached a level that harms the quality of public price discovery, market transparency and execution quality. The SEC asks whether depth of book should be protected under the SEC's current trade-through rule or whether a "trade-at" rule would be appropriate. A "trade-at" rule would prohibit any trading center from executing a trade at the price of the national best bid and offer (NBBO) unless the trading center was displaying that price at the time it received the incoming contra-side order.
Although the recent regulatory proposals have been largely limited to the equity markets, market participants should watch for initiatives from regulators that could affect the strategies utilized in derivative markets, including equity options and futures contracts. While the CFTC has, so far, focused on position limits and the clearing of over-the-counter (OTC) instruments, the CFTC recently announced that it will also focus on possible issues related to co-location arrangements. It is important to watch for whether the CFTC takes any more specific reviews of HFT in light of the SEC's focus.
EU Regulatory Initiatives
As is often the case, the EU authorities are one step behind the U.S. in terms of putting forward concrete rule proposals in this area, but make no mistake, EU regulators are thinking along very similar lines as U.S. regulators and looking at largely identical issues.
The recent CESR "Call For Evidence" paper entitled "Micro-Structural Issues of the European Equity Markets" (the comment period for which ended on 30 April 2010) specifically lists HFT, sponsored access, co-location, fee structures and tick sizes as items about which it wants to gather information and areas which are under consideration for additional regulation. This is not to say that CESR has concluded that further regulation is necessary in all (or indeed any) of these areas, but CESR specifically asked for market participants' views in this regard.
In light of the SEC proposals to prohibit "naked" access, whereby unregistered firms can enter orders on markets in the name of intermediate exchange member firms without such firms conducting pre-trade vetting or filtering of such orders, it would be surprising if EU regulators did not move in a similar direction. Indeed, CESR notes the conclusions reached by the International Organization of Securities Commissions (IOSCO) when looking at this issue and the "risks arising from [sponsored access] for organized trading platforms and firms providing [sponsored access] to their clients," as well as IOSCO's proposals to address these concerns.
The EC Commission paper issued last autumn entitled "Ensuring Efficient, Sage and Sound Derivatives Markets: Future Policy Actions" is also highly relevant to high frequency traders. It focuses on the OTC derivatives markets and the systemic risks posed due to the lack of transparency and use of leverage in those markets.
The EC Commission has, in this case, put forward concrete proposals to reduce counterparty risk by:
- mandating clearing of "standardized" derivatives through central counterparty clearing houses (CCPs);
- creating a clear regulatory and supervisory framework for CCPs (whether conducting derivatives or securities business) and requiring such CCPs to be regulated;
- requiring market participants (which seems to include unregulated as well as regulated financial and non-financial firms) to post initial and variation margin in relation to OTC transactions, at significantly higher levels than that required for equivalent on-exchange transactions (to, in the EC Commission's words, "effectively ensure appropriate pricing of counterparty risk" and indirectly encourage on-exchange business);
- requiring regulated firms to carry higher levels of capital in relation to OTC business;
- instituting mandatory transaction reporting for OTC as well as exchange-traded instruments and requiring all "trade repositories" (i.e., trade reporting systems providers) to be regulated; and
- harmonizing pre- and post-trade transparency and reporting of trades and associated prices and volumes for both on-exchange and OTC markets.
While the SEC has acted to prohibit some potentially manipulative practices and some business methods that may impose systemic or other risks, and we can expect EU regulators to move in a similar direction, at present, there are no concrete proposals on either side of the Atlantic which fundamentally threaten HFT.
Perhaps the greatest danger to high frequency traders is that they do not fully participate in SEC, CESR and other futures regulatory initiatives, and thus do not have a chance to present their case. High frequency traders need to ensure that their voices are heard and that politicians and regulators (and competitors who may feel threatened by HFT) do not unduly restrict HFT due to misunderstandings.
It would appear that the OTC initiatives could have a profound effect on the trading for these products. One such effect would be to drive more trades onto exchanges, thus creating more volume and transparency, which could present attractive trading opportunities for high frequency traders.