In my first blog post, I discussed the skewed incentives, unfair playing field, and dangerous consequences of high-frequency trading (HFT). Is it any wonder that you could apply the same adjectives to the financial services industry in general? HFT is a destructive force in the markets: It increases the cost of trading for most people, rewards an activity that provides little to no economic value, and damages investor confidence in the fairness of equity markets. It is, however, symptomatic of much bigger and more deeply seated problems in the industry.
Before we tackle these encompassing problems, we should consider several actions that legislators could take to help dampen or eliminate the ill effects of HFT:
- Eliminate for-profit exchanges: The experiment in for-profit exchanges has been an utter disaster. The conversion of NYSE and NASDAQ from privately held, self-regulatory organizations to publicly traded ones has not worked. It is ironic that the financial services industry should be such a great example of capitalism's limitations. Stock exchanges should serve the general population by ensuring fair and orderly markets. Likewise, they should serve the companies that are listed or who want to list by ensuring robust price discovery and capital formation. This is the first step to instituting any reform. Our exchanges must take actions to reduce their earnings per share to ensure a more stable market and economy. That is a tradeoff most public companies are not willing to make.
- Mandate that liquidity providers fulfill obligations in order to collect rebates: If you're willing to take the other side of a buy/sell trade (in other words, you provide liquidity, often called "market making"), you usually receive a rebate from the exchange instead of paying a fee. Electronic liquidity providers perform a critical function and should be compensated for maintaining orderly markets. They take on inventory risk and that can be costly. However, historically there have always been obligations for market makers to continue to provide liquidity even during market turbulence. This is an obligation to which HFT firms are not currently beholden. This must change. The ability to collect liquidity-providing rebates should only be available to those firms willing to stay in the market when conditions become difficult.
- Level the data access playing field:
- Eliminate co-location: For the firm willing and able to pay for it, data center space is available for rental right next to the stock exchange. The closer you are, the faster you receive data. This, of course, only benefits HFT firms (and the earnings per share of for-profit exchanges), providing their servers information milliseconds before the rest of the market. It can be argued that this makes it non-public information. To many of these modern servers, milliseconds are an eternity. When I worked in the industry, I built models that would take 40 microseconds (40 millionths of a second) from when data hit the network card to when the trade was sent out to the market. I have no doubt there are faster systems out there now, and those reaction times will only continue to decrease.
- Eliminate direct market data feeds: These are the feeds coming directly from the exchange providing updates every time something in the market changes. These are only useful if you have tremendous computing power to process upwards of 2 million events per second. (Unless, of course, you can do this in your head, in which case, good for you!). The Foreign Exchange (FX) markets have long worked well under a different model, and I'm not convinced that anyone would suffer from less data. If market data feeds simply sent out a snapshot of the full order book every 100 milliseconds, who would be worse off?
- Reinstate the uptick rule: For almost 70 years if you wanted to sell a stock short (i.e., wager that it would go down in value) you had to wait until that stock's price moved up. A change to this simple rule in 2007 opened the door for many high-frequency traders. If you are a student of history, you know that cyclically the world looks very similar to the time that rule was first passed (1938). Maybe it's time we reconsider? A long list of financial services experts (which notably does not include any HFT firms) agree with me on this one.
Unfortunately, without a substantial public uproar, I'm inclined to think the odds of any meaningful financial reform are very slim:
- It's already 2.5 years since the SEC decided, and most of the financial services world agreed that flash orders should be banned, and they have not been.
- Regardless of how many billions of dollars JPMorgan's prop trading desk loses, they (and others in the industry) continue to argue that institutions with federally insured deposits should still be able to "hedge" by making extremely large bets that look amazingly similar to the proprietary bets that the Volcker Rule is supposed to eliminate.
- The financial reform act negotiated by Congress was already dramatically weakened by the time it was passed, and the industry has deployed its band of lobbyists to weaken it further as the legislation is turned into actionable regulation.
Barry Ritholz gives some excellent suggestions in his most recent column on ending TBTF, while acknowledging that "[a]fter years of deregulation, it has become all but impossible to re-regulate modern banking. There was a brief window during the credit crisis, but that has passed. Today, profits trump soundness. Safety and security are secondary to risk-taking and speculation."
I couldn't have said it better myself. We have no shortage of great ideas for how to fix the system. We simply lack the will and the ability to push meaningful reform through our corporate-controlled, hyper-partisan government.
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