HFT: Still Dancing Around the Issue

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The Journal says this morning....

High-frequency trading firms, long resistant to tighter oversight of their businesses, are beginning to change their tune amid a spate of high-profile technology failures that have roiled financial markets.

The near-implosion of Knight Capital Group Inc. in early August sent shock waves through rival firms. The industry over the past decade has built a widening web of complex trading software and ever-faster computer systems designed to boost the speed of trading, giving traders with sophisticated computers an edge.

Note the slant -- a slant that is like most, founded on only the part of the story that the industry wants you to hear about.

Now, some high-frequency stalwarts have begun to worry publicly that the markets need new controls. A growing number are advocating for fixes they say may help avert catastrophe, and the Securities and Exchange Commission is meeting with companies Tuesday to begin hammering out a plan for dealing with a Knight-like meltdown.

Oh really? You mean the industry is looking for angles to preserve its ill-gotten (and arguably illegal) advantages?

Let's talk about those for a minute, becasue they're important.

One of the most-important differences that these firms exploit is margin requirement differences. If you are sitting behind your terminal you are prohibited by your trading platform from entering an order you cannot clear and all orders you have open but un-executed count, because they might execute.

For example let's say you have $20,100 in equity in your account and the per-contract initial margin for a futures contract you wish to trade is $5,000. You cannot have more than four orders outstanding to open a position at any given time that stand independently of one another. That is, while your brokerage might well permit you to have an order to buy a contract at 1400 and short one at 1398 as a "OCO" order (one cancels others) and count that as one margin requirement what they do not permit is for you to enter an order to buy one contract at 1400 and another at 1402 and another at 1404 and count all those as one margin; your margin capacity is dinged for all three because it is entirely possible that all three orders will execute.

More to the point you cannot enter five orders; the brokerage systems will prohibit it, as you can't clear those trades even if you believe that if the market goes your way by the time you get to the 5th order your unrealized gains and thus your liquidation value will permit its entry. You must wait until that happens before you can enter that 5th order.

But this rule does not apply to the HFT boys. They can (and do) have crazy numbers of outstanding orders at any given point in time, and they argue that having their clearing brokers be forced to police them to guarantee that they can clear every single order they place and have outstanding would be "burdensome." Well, maybe it would be and may it wouldn't, but if this rule had been in place Knight Capital could not have gotten itself into a negative equity position as the entry of positions leading to that scenario would have been prohibited!

Second, the HFT boys all "claim" they are subject to execution risk on every order, but this is not really true. Indeed, the entire point of many of their strategies is to not get executed on some material percentage of their orders. The problem is that this is illegal.

It is broadly illegal to place into the market an order that one does not intend to execute. That is, you cannot place an order into the market intended to goad someone else into acting, or through any other device attempt to manipulate price except through a bona-fide offer to buy or sell the security in question. The key here is "bona-fide"; an order placed and then immediately canceled where the entity doing so is trying to present the appearance of an interest to execute where one does not exist is illegal.

Since the Securities and Exchange Act requires that all orders must be intended to execute there's a simply way to prevent this sort of nanosecond game, where any part of the strategy involves "flashing" an order that isn't really intended to execute and thus clear through the exchange: Force all orders to be valid for two full seconds or until executed.

Why two seconds? Because markets are supposed to be fair and give everyone equal access to the capacity to hit a bid or offer. While it is indisputable that some people will be closer and thus faster to react, or simply be of "quicker mind" (as is true in a physical trading pit) the fact remains that an order that is presented in a physical trading pit can be hit by anyone in the pit, and once the hand goes up anyone there can hit the bid or offer you represent.

Two seconds gives ample time for the signal representing your order to transit the world in both directions (your dissemination of the quote and the other person's dissemination of meeting your price; offer and acceptance in contract parlance) and a reasonable amount of time for both human reaction time and order matching.

An order that is executed can be immediately replaced, so if you are executed in 10ms you can place another order as soon as you receive confirmation that the first one has executed. But what you cannot do is stick orders into the system and then immediately cancel them before any human can possibly react, thereby breaking the law as you are not (1) actually exposing your order to everyone to be executed against and (2) there is legitimate question as to your intent to execute in the first place.

Many in the HFT community will argue point #2. But point #2 is immaterial; if you do not intend to execute against anyone who desires to hit your bid or offer you're breaking the law; fair and clean public markets, along with the Securities and Exchange Act, broadly prohibit any action intended to manipulate price or disadvantage one party over another, and entering and canceling orders before a human can react is a clear violation of this principle.

If we take these two actions, which I have been advocating since this controversy came to the surface, all of the issues surrounding HFT disappear. Firms cannot put themselves into negative equity and the "hit and run" games involving abusive order patterns disappear since every order must be exposed to actual execution risk.

Two little changes, one big clean-up.

Let's do it.

Source: The Market Ticker

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