As regulators continue their struggle to define and police high-frequency trading, exchanges around the world are making a push of their own to rid the markets of one of HFT's most contentious — and potentially abusive — elements.
In recent months, exchanges have announced plans to roll out measures aimed squarely at eradicating the technique of quote-stuffing, a common strategy in which high-frequency traders rapidly fire off, and then cancel, millions of orders as a means to probe the direction in which the market is heading. While few of these orders are actually executed, the tactic has proven highly profitable for high-frequency traders.
The problem is, all these cancelled orders place a serious burden on the exchanges, while possibly obscuring price discovery for retail and institutional investors, experts say. As a result, a growing number of exchanges are gearing up to fight back with fees aimed at punishing high-frequency traders for excessive order cancellations.
[Can high-frequency traders ever slow down? In an exclusive interview, ITG's Jamie Selway discusses what's in store for HFT firms.]
Since late February, Borsa Italiana, Deutsche Borse and Nasdaq OMX each have announced plans to impose penalties on traders who send in too many orders that don't result in actual trades. And the exchanges have plenty of supporters. Earlier this year, U.S. Securities and Exchange Commission chairwoman Mary Schapiro said the regulator is considering a fee for traders who cancel too many orders as well. Meanwhile, the Commodity Futures Trading Commission currently is investigating the impact of high-speed, algorithmic trading on the markets.
Were HFT Fees Inevitable?
John Bates, founder and chief technology officer of Progress Software, says the recent moves by the exchanges were inevitable considering they've been forced to invest staggering sums in order to be able to process billions of orders. He also predicts that more exchanges will adopt the same stance.
"All these orders are putting tremendous strain on the exchanges. They have to put a large amount of money into network capacity, backups, disaster recovery," he says. "The expense and cost of being able to support all this, plus the fact that it's a smokescreen that's hiding abuses, is going to lead exchanges around the world to follow."
The industry policing itself like this isn't necessarily a bad thing either, since a market-driven solution is more apt to allow for adjustments on a day-to-day basis, according to Keith Ross, the chief executive of alternative trading platform PDQ ATS. "On a day when the markets aren't doing a lot, there may be 80 percent excess capacity at the exchanges," he explains. "Now you can knock yourself out and send as many cancel replaces you want; but on a really busy day, when they're at 85 percent capacity, maybe then they'll want to slow things down a little."
And if most of the messages that are being sent by high-frequency traders are truly extraneous, it won't have much of an impact on the marketplace if they're eliminated, adds Ross, who was previously CEO of the high-frequency trading firm Getco. A solution crafted by the industry also is more likely to work without dampening volumes, he suggests.
"When you create a regulation like that, it's extraordinarily difficult to find the right calibration," says Ross. "You have no clue what impact that's going to have on the market. How much wider are spreads going to go? How much liquidity is going to evaporate? What's the market structure going to look like? Certainly a market-driven solution would make much more sense."
To Charge or Not to Charge?
But Ross adds that most exchanges are likely to take a wait-and-see approach before adopting order cancellation fees of their own. Noting that high-frequency trading is responsible for roughly 50 to 60 percent of daily market volume, he also suggests that if tariffs are too high, they could ultimately result in less trading activity and liquidity in the marketplace.
"If high-frequency traders trade half the volume — which might be 3 billion or 4 billion shares a day — they're placing on the market 30 times that, or 125 billion shares of potential liquidity," Ross adds. "If the tariff is high and all of a sudden they have to fill half the orders that they send, well, they're going to send a lot fewer orders."
Progress Software's Bates, however, counters that there's ultimately a bright side to all of this. With exchanges beginning to crack down on excessive orders, market participants will have no choice but to develop smarter algorithms that can detect favorable conditions for transactions, as opposed to "stupid" algos that just blindly fire off orders, he says.
"Now I have to have different types of strategies," Bates argues. "It would weed out some bad apples, encourage smart and possibly self-learning algos that don't put such a load on the system. It's not going to stop algorithms; it's just going to change the way lots of them work."
Bates also disagrees with the notion that regulations to address runaway algorithms are likely to harm liquidity, since most HFT orders are unlikely to ever trade in the first place. New rules would also be useful in the most extreme cases, in which an algo gone wild may put in an order that's way off the best bid, he notes.
"It's not necessary for algorithms to exist to be able to fire out all these orders," Bates says. "In fact, it begs the question, is something suspicious going on?"