Social Benefits of HFT and Algo Trading: Regulators should Embrace them

Posted on Posted in Finance, Trading

The tremendous growth in financial trading volumes in the last couple of decades has been made possible only with the use of technology. Technology has helped in – automating the dissemination of market data and other relevant information by exchanges and trading participants – capturing and consolidation of market data from various exchanges and other sources of relevant information – making complex calculations on live and historic data, leading to trade decisions – trading and managing risk – lowering the latency and cost of trading – various post-trade processes Technology is heavily and generally efficiently used by brokers (providing various retail and institutional investors access to financial markets), high frequency traders (who trade in huge volumes aggregating small profits in as many trades as possible, this typically includes arbitrageurs and market makers), quant algo traders (who use quantitative models to predict the future prices etc.), exchanges (who are the liquidity aggregators forming markets), and various other market participants. Each stake holder mentioned above has a significant role in the orderly functioning of the financial markets.

Comprehensive Risk Management is the foremost requirement in managing these financial trading businesses. There has been a major backlash against the financial firms (primarily the ones driven by technology including HFT firms) especially since the Flash Crash – US markets in 2010, Knight Capital posting a major loss due to algo technology glitch in 2012, and various other events. According to some estimates, over 60% of US equity trading and over 30% of UK equity trading can be accounted to HFT firms. Regulators and Politicians across the world have tried to curb the algo and high frequency trading in particular by coming up with some fairly interesting proposals and arguments, – European regulator wanting Half-second delay before execution of a trade or cancelling an order in a bid to temper incentives of trading fast.

It’s like introducing a speed breaker on a high way. People will drive very fast up to the breaker, and speed up again once they cross it. It’s not that hard for HFT firms to adjust their trading algorithms to accommodate for this regulatory change and still do what they intend to do. – Indian regulator proposed that the exchanges to accept orders alternately from a co-location member (whose servers are located in the same physical location as the exchange) and a non co-location member. Depending upon the cost-benefit analysis, an HFT firm can setup a co-location server and a server in proximity to the exchange and alternate sending of these orders through those 2 servers by adjusting their strategy.

– Capping the order to trade ratios for all market participants

Technically the algos can work around this as well. But this can certainly help reduce some over-fishing in the market(i.e. algos sending too many smaller orders at wide limit prices and then cancelling them to search for trading opportunities which are not easily transparent).

– Certain regulators trying to have HFT players notify the exchange or the regulator of the algos used by them

Its part of Germany and India’s regulatory system, but does not curb the automated trading related over-trading triggers as the regulators or exchanges will not easily be able to understand the detailed functioning of the algos. They can only try and ensure the HFT firms ensure sound risk management and follow the practices strictly at the time of algo approval or audit.

-Retail Investor has a disadvantage and cannot access the same arbitrage opportunities due to lack of access to same technology as HFT firms

Retail Investor should not be trying to do sub second arbitrage the market in the first place. It’s like saying a cyclist cannot ride as fast as a car on a high-way and car-drivers should be stopped or slowed down. Retail investors should look to take slightly longer term view as they had been doing historically.

– Institutional investors can also not compete with the HFT firms’ rise in technology

HFT firms had been driving the use of technology and advancement to low latency trading. In their constant RnD process, they have stepped up in the technology value chain and have enabled the Institutional investors with good and efficient trading tools at affordable prices. For example, execution algorithms like VWAP, Smart Routers were not available to Institutional Investors a decade or two ago, but HFT firms led RnD and trading styles have made execution algorithms available to other Institutional as well as Retail Investors indirectly. Also, the objective of the Institutional Investors is typically to manage portfolios over with longer horizon targets rather than intra-day small price movements.

– HFT firms lead to market failures and crisis like Flash Crash in 2010, Knight Capital’s loss in 2012, etc.

In the absence of HFT, there had been ample crises in the financial industry (and in several other industries too) including the LTCM Crisis in 1998, Sub-Prime crisis in 2007, where the human processes have led to major crisis in the markets. The use of technology if  managed well and regulated efficiently can actually reduce the probability and scale of such events. For example, If an airplane crashes, it does not make the Air Travel a bad business. Air travel brings lots of benefits to our social and economic growth that it’s worth it despite rare unfortunate crashes. The regulators in that industry focus on ensuring the safety of passengers and plans is an utmost priority for the airlines. In a similar way, HFT firms understand the risk management priority and usually target to mitigate and manage risk first, and then focus on profits. HFT firms actually help in providing better liquidity in the market, lower cost of trading, tighter spreads, that help institutional investors and retail investors in getting their executions at better prices. Use of technology in the trading value chain has lead to split second order executions

– Imposing extra-taxes on HFT (like a regulatory proposal out there in Germany) make it expensive for HFT players and reduce their net profits. Such moves will either move the HFT firms to alternate venues or countries with lower or no taxes or hurt their profits up to a certain point, beyond which it does not make sense for them to be in the business (as some German HFT players are pondering to shut down)

Regulators across the world should embrace the constructive technology developments in financial markets that support growth of businesses and the economies. Their goal should be to understand the market behaviour, advancements in technology, bring transparency to the market, introduce risk management measures like a kill switch (for cancelling all trades when things go wrong), push for stronger stress testing of automation tools, enforce compliance, track patterns that may lead to systemic risks, and lead to a solid and comprehensive risk management across the financial industry.

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