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December 16, 2010

2010 Review: HFT Strategies Ignite Debate

By James Ramage

HFTs have answered Kaufman and the QSG study by arguing that institutions have the same tools and techniques to move their blocks that HFTs use. Furthermore, they said, anytime someone buys a large number of shares of, say, IBM, it will affect demand and should, in an efficient market, trigger a rise in the stock's price. Thus, they added, traders who want their large blocks executed without any impact on the price are essentially asking other market participants to subsidize their trading.

Next, some in the industry accused HFTs of "quote stuffing," a practice where traders with the fastest technology flood the exchanges with thousands of quotes a second that never result in a trade. All that quoting, detractors argued, overwhelms an exchange's systems and slows it down. The fastest traders could then arbitrage stock prices on other exchanges for gains. Many HFTs, though, countered that the practice didn't exist.

Finally, the May 6 "flash crash" prompted outcry from regulators, politicians and industry figures that the market has been lacking support from dedicated market makers, and HFTs quickly got tethered to the tempest. At the crash's height, bids virtually disappeared during a four-minute period and the market toppled.

HFTs, which these days are seen to contribute almost 50 percent of bids and offers in the market, were accused of desertion. The group of hyper-fast traders was ultimately exonerated by a joint SEC-CFTC study of the flash crash at the end of October, but May 6 only increased the suspicion that they are the root of all that is wrong with current marketplace.

And this time, regulators, politicians and industry executives again called for the HFTs to assume stiffer quoting obligations and possibly be registered as market makers.

The SEC has been keen on the idea. In the wake of the flash crash, it pushed the exchanges to impose tougher quoting obligations on registered market makers and has been mulling the imposition of market maker obligations on HFTs.

SEC Chairman Mary Schapiro told members of the Economic Club of New York in September that it might not be a bad idea for HFTs to assume both positive and negative obligations akin to those of the New York Stock Exchange specialists of yesteryear.

Following the crash, four HFTs--Quantlab, RGM Advisors, Allston Trading and Hudson River Trading--responded in a joint September letter to the SEC. They wrote that even tightening obligations on registered market makers beyond the proposed 8 percent collar would be fraught with potential problems. Because exchanges would have to pair benefits with the obligations, the result would be a two-tiered market, some argue, making it difficult for newcomers to enter the business. "Since there appears to be broad agreement that increased obligations would not prevent market failures, this cost is simply not justified," their letter said. The HFT debate is expected to continue to spill over into 2011.


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