High-frequency trading once again finds itself in the spotlight, as it has been several times since the Flash Crash of 2010. This time though, attention surrounding Michael Lewis’ latest book Flash Boys, means that high-frequency trading, or HFT, is being judged in the court of public opinion at the same time it is the subject of investigations by the New York Attorney General, the Federal Bureau of Investigation, and the U.S. Department of Justice.
The scrutiny is well-deserved. Technology and the proliferation of trading venues have moved faster than regulation, creating structural issues in markets that need to be addressed. To be clear, neither technology nor the increased number and variety of exchanges is the true issue. In fact, the efficiency of computerized trading and greater choice in trading venues are, on balance, very good things – having improved the process of price discovery and reduced transaction costs for investors. The issue with certain HFT firms is that they take advantage of speed and preferential access to exchanges to engage in predatory trading practices. The New York Attorney General refers appropriately to the situation as “insider trading 2.0.”
Our long-standing position, in published papers and conversations with regulators dating back to 2010, has been that HFT firms’ predatory practices harm long-term investors and undermine trust in markets. Transparency and fairness are critical to the effective functioning of markets. And it is essential that markets are organized in a way that encourages all investors to trust that they will be treated fairly.
Thanks to Mr. Lewis’ work and the ongoing investigations, the predatory nature of some HFT firms is becoming better understood. Specific elements we find most concerning include
- Direct or sponsored access, whereby HFT firms pay for preferential access to exchanges
- Co-location of HFT servers within exchanges in order to provide a speed advantage
- Order and trade cancellation, which occur on a massive scale partly as the result of HFT firms “pinging” orders to trade ahead of legitimate orders
- Information about trades apparently being passed to HFT firms, sometimes for a fee
Defenders of these predatory practices suggest that they are simply profiting from current market structures, and that their actions don’t violate existing regulations. That is an argument that time (along with the investigations now underway) will resolve. In the meantime, consider this line of reasoning. Shouldn’t an investor be able to expect that no one will be able to act on the information conveyed by its trade orders ahead of the market? If so, how is a HFT firm’s use of preferential means to front-run a trade order (with the impact of increasing the investor’s cost for that trade) different than insider trading?
Fortunately, large, sophisticated investment managers like Principal Global Investors have the means to protect their clients in this environment. Among techniques we employ to protect clients from front-running are trading strategies that minimize signals sent to other market participants and use of “dark pools,” an unfortunate name for exchange-like trading venues where we can place large orders while protecting confidentiality.
However, these are adaptations rather than solutions. Moreover, effective markets demand fair treatment for all participants. The real solution involves structural reform.
There are a few specific areas where we believe structural reforms would go a long way toward rebuilding transparency and fairness:
- Action against sponsored access and co-location. These practices convey speed advantages on favored firms that can translate into enormous profits to the detriment of long-term investors.
- Prohibition on exchanges paying for order flow. This practice results in an inherent conflict of interest between brokers’ need for revenue and their obligation to get best execution for their clients.
- Action against predatory use of order cancellation. One approach could be imposition of messaging fees. Attaching modest charges to trade orders would not significantly affect legitimate investors, but would have the positive impact of making uneconomic the thousands upon thousands of orders HFT firms send out to “ping” the exchanges. This is a case where a small change could have a very large impact.
- Reducing the practice of trade cancellation, which was used extensively in the Flash Crash. If cancellations are too easy, traders and particularly HFT firms are encouraged to get careless.
- Prohibition of market stop-loss orders, which can be manipulated against investors by HFT firms deliberately moving the market.
- Restoration of the uptick rule. Introduced in the 1930, it essentially prohibits short selling unless there is two-way activity in a stock. The uptick rule was temporary reinstated following the Flash Crash, and see it as an important tool to combat market instability.
- Restriction on information use within dark pools and other trading venues. As described above, dark pools serve a legitimate purpose, but the fact some dark pool operators also engage in proprietary trading creates the appearance of conflicts and potential for abuse. Additional controls are needed to ensure operators don’t use privileged information to their own advantage.
We closed a 2011 paper with the admonition that actions to increase transparency and fairness in equity markets were “too important to wait”. That was true then, and is even more so three years on.
For those who are interested, here are some links to our thinking on HFT over time. Lessons from the Flash Crash was a piece that I’d put together in May of 2010 on the issues HFT presented in the wake of the Dow Jones Industrial Average falling by nearly 1,000 points in 20 minutes. Then, in December of 2011, I’d written some thoughts, referenced above, on how HFT should play into the views of long-term investors in a paper called Today’s Equity Markets: Insights for the Long-term Investor. For background on the development of electronic trading and HFT, I’d recommend a 2012 paper called Rise of the Machines, authored by Huw Gronow, a senior equities trader at Principal Global Equities. Huw also put down some thoughts last week on how HFT affects his trading strategy in a blog post called “The Most Interesting Aspect of Michael Lewis’ Flash Boys.”
The information in this article has been derived from sources believed to be accurate as of April 2014. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.
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