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The Rat Race to Regulate High Frequency Trading

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As Aerosmith famously sang: "Rats in the cellar... losin' money, getting no affection." Lately, HFTs have been compared to everything from rats in a granary to highway robbers intent on stealing Granny's pension. Bashing high frequency trading firms has become the latest sport in the financial services industry. So much so that the Futures Industry Association has publicly taken exception to the "emotive language" being assigned to HFTs.

"For example, many people don't realize that market abuse -- as well as being morally reprehensible -- comes at a hefty price for the market. So principal trading firms such as our members have a very real economic incentive to fight market abuse and back regulatory reform," said FIA European Principal Traders Association chairman Remco Lenterman. He noted that the industry's critics chose to overlook the value that principal trading firms add to the real economy in terms of lower transaction costs and greater liquidity, according to Finextra.

While it is true that HFTs have a vested interest in keeping market abuse to a minimum, it is not yet clear that their liquidity has been healthy enough to withstand the pressure of incoming regulations. Despite the emergence of HFTs as liquidity providers, volumes in U.S. equity markets have not only failed to recover since the 2008 financial crisis they have continued to fall. In April, the average daily trades in American stocks on all exchanges stood at nearly half of its peak in 2008: 6.5 billion compared with 12.1 billion, according to Credit Suisse Trading Strategy. Many market participants blame this drop in volume on impending regulations including Dodd-Frank and SEC/CFTC efforts to reign in HFT dampening their enthusiasm.

Others blame HFTs for helping to undermine investor confidence. Articles in mainstream press pointing out that exchange maker-taker rebates drive trading volumes to those exchanges that pay the best rebates don't give investors any more confidence in the system either.

Add to this the rats in the granary-style comparisons and investors are beginning to lose complete faith that they can get a fair deal, or that they are even on a level playing field. They see the rats nibbling away at the best bits of grain, while the regulators' cat is still trying to figure out how to get in. We have compared the regulators' struggle with using bicycles to chase Ferraris; Former SEC enforcement lawyer Philip Khinda compared it with "bringing a knife to a gunfight."

However you describe the fight, since the Flash Crash two years ago seemingly little has been done by regulators. There is evidence now that, as originally suspected, HFTs did contribute to or even cause the crash. In-depth studies by data firm Nanex dispute the SEC and CFTC's reports that the crash was triggered by a single, bad algorithm belonging to fund Waddell & Reed. Nanex's report suggests that instead it was HFTs removing liquidity from the volatile market that triggered the crash.

There is no question that regulators face an uphill battle to try and control the issues that can be caused by, or exacerbated by, HFTs. But it is difficult to see how they can begin to take charge of the gunfight/granary/Ferraris without visibility. Some forward-looking regulators in emerging markets are using the gift of hindsight to be more proactive in their approach. Brazil, for example, has benefited from this 'second mover' advantage, by paying close attention to the lessons learned in the U.S. and Europe. Bovespa -- the nation's largest exchange -- has never allowed naked access, nor does it have a maker-taker fee model to encourage volume. There are no flash orders, and no NBBO , which was a consequence of fragmentation in the U.S. Brazil has always insisted on pre-trade credit controls and never allowed dark pools.

I am not advocating that regulators in the U.S. and Europe perform draconian reverse engineering to level the playing field. With a little better foresight, i.e. visibility provided by transparency, they can see and respond to market abuse before it occurs. And hopefully bring some investor confidence back to the markets.