Is it too much to ask for objective analysis? Is it unreasonable to expect unbiased research and information? Is it radical to suggest independent solutions to our problems that aren't plagued by conflicts-of-interest? Unfortunately, where the world of finance is concerned, the answer is typically "yes." More specifically, in fact, the answer is usually "what are you, some kind of naïve hippie?"
I might be a naïve hippie. I've been called worse. But when it comes down to it, I'm a believer in basic human reason and common sense. So when something like the Foresight report is released, it is a shock to my naïve hippie sensibilities. The UK government sponsored this investigative study. They enlisted the help of over 150 people in 20 countries, and you might assume that they gathered with the best interests of global citizenry at heart. Certainly, many of the folks involved were. However, according to this excellent expose by The Bureau of Investigative Journalism, the majority of the High Level Stakeholder Group has ties to HFT. The kowtowing to industry and pro-HFT conclusions of this report are therefore not a surprise.
The list of those involved reads like a who's-who of HFT proponents. Even Paul Wilmott, the guy who literally wrote the book on quantitative analysis (multiple books in fact), was discretely dropped from the project when he told them his pragmatic views. This is not how you conduct research. Those responsible should be held to a higher standard of objectivity given how important this topic is to the global financial system. The implications of this report could affect hundreds of millions if not billions of people, and they insist on the same tired, old arguments, including:
- Liquidity, as measured by bid-ask spreads and other metrics, has improved;
- Transaction costs have fallen for both retail and institutional traders, mostly due to changes in trading market structure, which are related closely to the development of HFT in particular;
- Market prices have become more efficient, consistent with the hypothesis that CBT [Computer-Based Trading] links markets and thereby facilitates price discovery
Is it even worth picking apart these conclusions anymore? How many times must they be refuted, or fail to meet the burden of independent proof? The most egregious offense underlying these assumptions is that these finance experts apparently have no idea just exactly what High-Frequency Trading is. If they did, they would not conflate this practice with the computer revolution that has swept Wall St. The computerization of Wall St has led to amazing efficiencies that have made the 3 points above true. This evolution has occurred over several decades. HFT is, by contrast, a new phenomenon, only truly hitting its stride in the late 2000's. There is absolutely no evidence that market conditions have improved since the late 2000's, and in fact there is substantial evidence that the trend has turned in the wrong direction. I cited several excellent, independent research papers detailing this wrongheadedness in my testimony to the Senate Banking Committee, nearly all of which were conveniently ignored by the Foresight panel.
Another one of the report's claims: "Economic research thus far, including the empirical studies commissioned by this project, provides no direct evidence that HFT has increased market abuse." As President Obama enjoyed saying recently, "that is simply not true." It is easy to produce biased surveys or ignore independent surveys, but there is substantial evidence of market manipulation and abuse, once again as cited in my Senate Testimony.
While it's not worth examining every claim, we can take some of their conclusions at face value. For example, they conclude that "While overall liquidity has improved, there appears to be greater potential for periodic illiquidity." In other words, the market is working fine, except when the Flash Crash happens, for reasons that are not understood. But don't worry, everything's ok. Except when it isn't.
They also conclude that "in specific circumstances CBT can lead to significant instability. In particular, self-reinforcing feedback loops, as well as a variety of informational features ... can amplify internal risks and lead to undesired interactions and outcomes." Shouldn't this be a terrifying conclusion? I'm afraid what we've lost sight of is the potential for computer-based markets. We are truly missing the forest for the trees. The technology revolution should have ushered in an incredibly resilient market, able to absorb large trades and even disturbances from individual participants without anyone noticing. Instead what we have is a fragile market, as the report admits, subject to disturbance by individual firms and even individual servers, with no understanding of the non-linear causes of these disturbances.
There's a saying that exceptional claims require exceptional evidence. When you ask the HFT industry to support their claims, they either cite research that is industry-sponsored, or they setup a straw-man argument against the specialist system. When you try to tell them that there is ample evidence contradicting their claims in studies performed in the past few years, they will argue that increased volatility and catastrophic event frequency is a result of the financial crisis. You can't have it both ways. HFT is a transformative force in the market, and they should be bending over backwards to ensure that there is ample evidence proving the benefit, and that the research is performed by independent groups. Instead they are bending us over.
Finally, the recommendations of the report are as frustrating as the conclusions. They recommend doing the absolute minimum, as the industry in the United States has constantly pushed for - kill switches and circuit breakers. It is shocking that anybody is still realistically arguing for static kill switches, given the possibility that they will severely exacerbate an unstable situation. Why must we always fight the last fire (in this case Knight Capital) rather than developing the foresight to anticipate and address the next one?
The report also dismisses many of the recommendations that continue to be made by those of us that are independent from the industry, including: a strategy registration system (no it would not be overly burdensome, as nearly every firm already has something like this); enhancing off-exchange/dark execution standards (as they do in Canada); taking on the disaster that is maker-taker pricing; and mandating market making obligations for firms collecting rebates and serving as market makers.
I do not mean to give a pass to the industry in the United States of course. Speaking of conflicts-of-interest, suddenly Credit Suisse has decided that Light Pool will be the white knight for the institutional investor. That is, of course, if you can ignore Crossfinder, their dark pool with an average trade size of 150-160 shares. Instead of a haven for institutional investors, Credit Suisse has built a Mecca for HFT in Crossfinder. To recycle a previous analogy, Credit Suisse building an exchange to protect against HFT is the fox building the hen house. For some reason I can't shake the mental image of a box held up by a stick, and Credit Suisse holding the string.
The frustration of those of us arguing for pragmatic, unconflicted reforms and unbiased research should be evident. I am thankful that here in the United States, the SEC has at least begun to realize the need for more independence in its research and panels, and I hope that trend continues. The UK could be well served by following that example.