Jim Angel called the flash crash.
In an April 30 letter, the Georgetown University professor and market structure expert told the Securities and Exchange Commission that “with so much activity driven by automated computer systems, there is a risk that something will go extremely wrong at high speed.” Six days later he was proven correct.
On May 6, around 2:40 p.m. EST, after modest selling pressure throughout the session, the stock markets took a swan
dive and the Dow Jones Industrial Average plummeted 1,000 points. Within 20 minutes, selling abated and the index rebounded 700 points to close the frenetic trading day down only 348 points.
But the carnage included nearly 21,000 canceled trades, with some stocks trading for as little as a penny. Investor outrage ensued. And inquiries from the media, regulators and government officials followed, demanding to know just what had happened in such a short time frame.
Five days after the crash, Angel again wrote the SEC, essentially saying, “I told you so.” He repeated his plea that the SEC force the market centers to impose “an automated marketwide trading halt in any instrument that falls 10 percent in a short period of time.” Within two weeks of the crash, the SEC did just that, pushing the exchanges to adopt circuit breakers on the stocks in the S&P 500 Index that, if triggered, would halt trading for five minutes.
Speed Limits
I’m delighted by the move,” Angel told Traders Magazine. But the academic, who once designed risk models at BARRA, said he’s worried about some of the other curbs on trading speed the Commission is contemplating.
Even before May 6, the SEC was already concerned that the activities of short-term traders might be harming long-term investors. In its Concept Release issued in January, the regulator divided the trading world into two camps: short-term and long-term investors. It questioned whether the speedy first group was putting the second group at a disadvantage.
Advocates for short term traders cried “No!” but the events of May 6 didn’t help their cause. By June 10, the SEC was making ominous noises about speed limits.
At the annual meeting of the International Organization of Securities Commissioners in Montreal on that date, SEC chairman Mary Schapiro told the gathering that the Commission was investigating whether it would regulate speed. The SEC, Schapiro said, would “explore whether bids and orders should be regulated on speed so there is less incentive to engage in this microsecond arms race that might undermine long-term investors and the market’s capital-formation function.” Gary Gensler, chairman of the Commodity Futures Trading Commission, seconded Schapiro’s comments. “All too often, people confuse volume with liquidity,” he said at the same conference in Montreal. “The average holding period may have been a matter of seconds. Is that really liquidity?”
Sen. Ted Kaufman, D-Del., a critic of high-speed traders who first caught the industry’s attention in 2009 with his attacks on short selling, supports Schapiro’s way of thinking. Kaufman endorsed her comments that the SEC should explore whether to regulate the speed of trading. He said in a June 11 letter to the SEC that markets should not be reduced to a battle of algorithms in which long-term investors are an afterthought and relegated to second-tier status.
Never before in the history of equity trading has so much stock traded so quickly. According to data from Chicago-based market data vendor Nanex, on a typical day Citi stock trades about 24 times every second, compared with only five times per second in 2006. Ford trades about five times per second, versus about once per second in 2006. And while there is little variation in price on a second-to-second basis, within one second there are myriad peaks and valleys, according to data from Corvil, a latency consultant.
While the increased speed of trading is cited as a natural outgrowth of the drive toward efficiency and firms engaged in high-frequency trading are generally praised for providing liquidity, there are many who believe trading at warp speed is going too far. They contend that the stock market exists to match long-term investors with businesses seeking to raise capital, and that hyper-fast trading conditions breed speculators who only make raising capital more costly for corporations.
The SEC has put forth at least three ideas that, if they became rules, could alter the playing field: set a minimum trading speed; require a minimum amount of time a trader must maintain a quote; and require exchanges to batch process their trades.
Michael Goldstein, a professor at Babson College in Boston, explained that batching trades not only allows traders a brief moment to check the markets, but to double-check for events that algorithms aren’t programmed for-like an event that dislocates pricing, such as a national catastrophe, whether man-made or a natural disaster. He suggested leveling the playing field by executing batches of buy and sell orders in 10-millisecond intervals.
“Trading happening at one millisecond or faster isn’t the purpose of the stock market,” Goldstein said. “It’s to allocate capital, and I believe it hasn’t been doing that since 2007.”
Goldstein raised the issue of overly fast trading at an SEC market structure roundtable in June, suggesting that the SEC should consider imposing minimum and maximum speed limits on trading, as the government does on the nation’s highways.
Concerns that trading is happening too fast are not limited to Washington and academia. Industry executives are also questioning the need to trade in microseconds. And they are letting the SEC know how they feel.
The Industry Speaks
At the SEC market structure roundtable, Kevin Cronin, director of global equity trading at Invesco, a money management firm with $581 billion in total assets under management, told the SEC he was concerned that too much speed might be negatively impacting the market’s price-discovery process. “I’m not sure the two aren’t inversely related at some point,” he said. “The more speed you have, the less price discovery you have.”
At a hearing conducted by both the SEC and the CFTC in June, Jeff Engelberg, a trader with Southeastern Asset Management, told the regulators that speed exacerbated the May 6 crash. “It appears that low-latency co-located strategies were calibrated for a more stable environment, [but on May 6] they continued to trade by the microsecond, reinforcing and strengthening the downward negative spiral,” he said. “There are few events in life requiring decision-making which can be altered in less than a blink of an eye. We do not feel that securities trading falls into that category.”
Chris Nagy, managing director, order routing, sales and strategy, at TD Ameritrade, told the SEC in a letter that “rapid order placement and high cancellation rates have only exacerbated flickering quotations, which undermine retail investor confidence in the execution quality they obtain.”
Even some within the ranks of electronic trading are calling for caution.
Thomas Peterffy, chairman and chief executive of Interactive Brokers and a pioneer in the use of technology for trading, said at a recent industry conference: “There is generally an issue with automation that you have to put many, many safety valves on your technologically sophisticated systems. The oil spill is a woeful example of that. Yes, automated systems can run away. So if you do not have very significant facilities to prevent them from running away, it’s a problem.”
And while most exchanges defend speed and say it is part of the natural evolution of the markets, at least one is not completely comfortable with it. Nasdaq OMX told the SEC in a letter: “Speed is not inherently unfair or harmful; it is the misuse or misapplication of speed that may harm investors or markets.” In other words, traders who use their speed advantages to engage in manipulative activities should be censured.
The earliest beneficiaries of the market’s drive to zero latency have been the high-frequency crowd employing speed-based strategies. Hedge funds and broker-dealers using high-frequency trading strategies have embarked on an arms race to employ better-and faster-technology that has driven trading speed into the microseconds, or millionths of a second. Black-box traders have pushed exchanges and other suppliers of infrastructure to rev up their engines, provide them with direct data feeds and sponsor co-location. In return they have pumped enormous amounts of volume into the market centers. And while the drive to zero latency has resulted from a partnership between exchanges and high-frequency traders, it is the HFTs that have borne the brunt of the criticism.
But their growing presence is speeding up the markets, and faster markets have some participants worried.
The issue of speed has manifested itself in two ways: a sense that market prices are more volatile, and a that some players-namely, those using HFT strategies-have time and place advantages over others.
Market Volatility
At its most benign, the instability of pricing manifests itself as flickering quotes, critics of hyper-fast trading say. At its most virulent, the volatility emerges on days such as May 6. Although there is little evidence that trading in milliseconds or microseconds exacerbated the market’s flip-flop on May 6, the perception exists that it did.
Joe Cangemi, head of equity sales and trading at ConvergEx Group’s global electronic trading unit, maintains that speed had to do with the short-term duration of the flash crash.
“We built a fast market with Reg NMS,” Cangemi said. “And we had on May 6 the fastest crash and recovery. We should have expected this. A fast market creates fast crashes and fast recoveries.”
However, others contend there is no data to support the thesis that faster trading speeds or markets push volatility higher. While the VIX has shown that volatility has risen from a low of 10 in mid-April to 26 in mid-July, peaking at 47 in May, sources say the increase in volatility was in fact due to macroeconomic factors-such as the European debt crisis, the BP oil spill and the nascent U.S. economic recovery-rather than speed.
“Where’s the beef?” asked Angel. The finance professor said he hasn’t seen any data proving that speed breeds volatility. “I would love to see the data on that, because it would make a really cool paper.”
Quote Flickering
In fact, Angel did a study comparing short-term volatility for all U.S. exchange-listed stocks measured at one-minute, five-minute and 15-minute intervals relative to volatility at the one-hour interval. He concluded that there has been no discernible increase in these volatility ratios over the past several years, indicating to him that high-frequency trading has not been a short-term disruptive influence.
Even if exchange computers operated more slowly-at one-second speed intervals, rather than one millisecond-the market would still be subject to extreme volatility if spooked by macroeconomic conditions, Angel added.
If today’s high-speed trading does not contribute to extreme price moves, so-called “quote flickering” has become a problem for many. Quote flickering occurs when quotes are posted and then quickly disappear. The phenomenon is not new. It emerged when the industry moved to trading in 1-cent increments in 2001. But high-frequency trading stratgeies. which often involve a tremendous amount of cancellations, has brought the problem to the forefront.
Nagy told the SEC that retail investors expect to be able to trade at the prices they see on their computers and “do not accept the excuse that the quote they saw is not attainable.” The exec petitioned the SEC to make quotes effective for a minimum amount of time. The SEC is taking the request seriously. SEC commissioner Elisse Walter broached the topic at the June market structure roundtable.
Sal Arnuk, a partner at Themis Trading who participated in the roundtable, told Walter that vanishing quotes were a routine affair that bedeviled him almost daily. There may be liquidity in the market as he begins to trade, say, a 50,000-share order, but it disappears in the middle of his trade. Buyers or sellers fade when they get wind of a buyer or seller, he explained.
“Speed is tied to the quality of the quotes,” Arnuk said. “Speed is good when it is good for everybody and everybody is playing on the same field. But when certain participants use a co-located advantage to make markets, they will pull their quotes.”
Market makers counter that they have the right to cancel their quotes when they want, to protect themselves.
Liam Connell, chief executive at Chicago-based high-frequency trading firm Allston Trading, told Traders Magazine his quotes and orders are akin to probes into the market. They provide him feedback on the state of the market. The thinking goes: The more quotes and orders placed, the more information he gets-and that makes for more efficient markets and better pricing for all the market, including retail investors.
The SEC and others have broached the idea that the markets might be best served if traders maintaining quotes for some minimum time period. The idea does not sit well with Steve Schuler, chief executive of Getco, a high-frequency market-making firm. “It’s a slippery slope if you regulate how long someone has to hold their quotes,” he told Walter. “It would be a big mistake to slow everything down to the lowest common denominator. We would not have the most competitive markets in the world if we did.”
The parallel argument against hyper-fast trading is that it is unfair for some market participants to be faster than others. Those traders who believe they’ve been put at an unfair disadvantage cite two bones of contention: direct data feeds and co-location.
For traders looking to trade faster than others, it is typically necessary to take data direct from exchanges rather than purchase quote and trade information from a consolidator such as Bloomberg or Thomson/Reuters. The direct feeds populate algorithmic trading engines faster, allowing traders to react faster than those without such feeds. The drawback is that the direct feeds are more expensive.
Some in the industry want the SEC to outlaw direct feeds and require all players to get their market data from the same source. The Investment Company Institute, which represents mutual fund companies, told the SEC in a letter that “the Commission should consider eliminating the two-tiered distribution of consolidated quote and tape information.” The ICI believes all traders should get their data from the same source.
Southeastern Asset Management, an advisor to Longleaf Partners mutual funds, feels the same way. Head trader Deborah Craddock and others executives told the SEC that “fairness would dictate that public price information be released to all market participants simultaneously.”
Co-Location
Bank of America Merrill Lynch, on the other hand, contends that the problem is with the parties that own and operate the consolidated tape feed from which the market data vendors get their raw data. BAML believes a lack of investment by the members has caused the tape to lag behind other data products. BAML argues the SEC should “encourage, if not require” an upgrading of the tape.
So instead of focusing on the effects of speed, attention has shifted to co-location. Sources have pointed out that the market’s fastest traders are often co-located and have a distinct time and place advantage. This advantage allows them to beat slower traders to the fill and to get crucial market data. High-speed trading, augmented by co-location, can prove formidable for slower participants.
Tabb Group reports that while nearly one-third of the buyside is in favor of such a ban, the sellside and execution venues are emphatically opposed to such a move.
Co-location involves a trading firm placing its computers and servers within the same facility as the exchange’s matching engine. The thinking goes that the closer a firm is to the matching engine, the faster it gets market data-and therefore it can react and trade faster than the competition. Getting the fill on a trade first, after all, is the name of the game.
But the question of a potential conflict of interest arises now as the exchanges, who operate the marketplaces, have entered the co-location business by building their own data centers and selling space. This began when exchanges shifted from a nonprofit to for-profit operating model, an evolution many believe started with implementation of Regulation NMS. As electronic trading grew after passage of Reg NMS, exchange revenues fell, leaving venues to search for new revenue. One solution the exchanges devised to deal with revenue loss was offer clients co-location services.
Exchanges Speak Up
The exchanges, aware many are pointing fingers at them for the problems surrounding May 6 and for catering to select groups of customers, fired back. They argue that all clients are treated fairly and equally. Not to do so, they contend, would be a direct violation of public trust and hurt confidence in the markets.
“If we gave any client or investor any type of preferential treatment over another, we’d be run out of business quickly,” said Randy Williams, spokesman at Kansas City, Mo.-based BATS Trading. All of BATS’s 450 clients or investors, which range from Getco to Lime Brokerage to Tradebot, receive the same services, such as free basic data feeds, and pay the same for trades, he added.
Joe Mecane, executive vice president at NYSE Euronext, said his exchange offers co-location to almost anyone who wants it. He dismissed the arguments of those who say co-location is only available or limited to high-frequency traders.
“The reality is, co-located equipment is used by people who deploy high-frequency trading algorithms-but it is also used by almost every bulge bracket investment bank, every wholesaler who is executing on behalf of retail orders and virtually every algorithmic trading firm,” Mecane said.
However Arnuk begged to differ on the firms that co-locate. He said firms that aren’t co-located are placed at a distinct disadvantage. He compared trading and co-location to the type of car one drives on a freeway and that one shouldn’t be obligated to buy an expensive sports car in order to compete on a level playing field.
“The exchanges will always retort that co-location is available to all, and so it is fair,” Arnuk said. “Of course it is available to all, as is a $1.7 million Bugatti Veyron, which does zero to 60 in 2.6 seconds. But should that class of car be the minimum required to play? If I only need a Civic, or more realistically the V6 Camaro, should I be forced to buy the Bugatti to drive on the freeway?”
Retail brokers also worried that while exchanges tout fair and open access to co-location, they’ve implemented very low barriers of entry. Thus, the subsequent amount of message traffic moving to and from the exchanges and data centers has risen tremendously.
Bandwidth, a precious commodity, they say, is being monopolized by co-located HFTS who can send millions of orders and cancellations during a single trading session. In the end, it pushes out the average retail investor’s order, a point the SEC is making.
While acknowledging spread costs have come down because of co-located HFTs, retail brokers like TD Ameritrade note that these firms enjoy a time and place advantage. Their advantage in getting news and quotes before everyone else won’t last forever.
“They get info much faster than a retail investor in Iowa with a basic modem, but over time those gaps tend to close, such as when more firms or everybody co-locates,” Nagy said. “That is what is beginning to happen now.”
The bulge bracket firms are reserved when talking about the relationship between the exchanges and high-frequency traders, as they deal with both daily. The bulge said the markets were best served as long as services are transparent and fair. Otherwise, the exchanges could find themselves in the regulators’ crosshairs.
“I think they’re OK so far,” said Owain Self, EMEA and Americas head of algorithmic trading at UBS. “But, there have to be strict guidelines on what they offer and how they offer it. They should be made to deliver these facilities in a scalable fair manner to all members.”
Anyone who wants to co-locate should be able to, traders at bulge firms said. But several did note that, as HFTs constitute a large amount of exchange trading business, their influence at certain venues bears scrutiny, to make sure the for-profit exchanges are fairly allocating space in a transparent manner.
The exchanges agreed.
“Our point is that it’s healthier for the market if co-location is overseen by regulated exchanges, where the pricing is public, space can be fairly allocated and it is under the SEC’s jurisdiction,” Mecane said. “If exchanges didn’t provide it, you’d basically have the Wild West in terms of people trying to sell real estate proximity to the matching engines without any oversight.”
