Letter of the Law

If there’s one universal constant in the professional world, it’s that you’re only as good as your last success. In journalism it’s your last exclusive, and in sales it’s hitting your last target. In finance, meanwhile, it’s your last profit margin.

No matter how good your track record might be, however, past success guarantees you nothing—as the high-frequency trading (HFT) community found out last year with the Flash Crash. Algorithmic trading of the high-frequency variety was labeled as responsible for the narrowly averted disaster, and since then HFT has become a dirty word in the mainstream press.

Other horror stories have also emerged, such as the oft-quoted tale of a company that went bust in less than 20 seconds when an employee inadvertently fired up a rogue algorithm. Inevitably, there has been a huge focus of regulatory chatter around the practice.

Proposed legislation could include minimum resting periods during times of extreme volatility, mandatory registration for firms that execute more than a certain number of trades per day, and obligations for HFT firms to become market-makers. Some of these developments have enjoyed support from the financial community—such as the Securities and Exchange Commission’s (SEC) ban on naked access to markets—but others have also been received with confusion and, in some cases, scorn.

“The main concern, I think, is the speed at which the regulation is being brought in rather than the vagueness of it,” says Stuart Adams, regional director for EMEA at FIX Protocol Ltd. (FPL). “It’s coming in slightly vague because the consultation is still underway, so I think the concerns are around whether we are trying to push this in too quickly. I don’t believe anybody’s really against regulation: most people understand that regulation is coming and that something has to be put in place to increase investor confidence. But the real concern is whether enough consultation been done.”

Political Engagement
The consensus appears to be that, although discussions are taking place, HFT firms in particular are playing catch-up at the moment. Although extraordinary amounts of money have been spent lobbying Washington over the Dodd–Frank Act, the fact that the first three months of 2010 saw $27 million, according to some estimates, collectively poured into lobby groups, large-scale groups of a similar ilk are only now emerging in the European theater.

“I don’t think there has been enough engagement from smaller traders,” says Rob Hegarty, managing director, global head of market structure at Thomson Reuters. He argues that regulation is often skewed toward large institutions that have the kind of resources necessary to deploy macro-scale changes in coding and software—benefits that are needed to comply with heavy regulatory reform.

“The HFTs recognize that,” he continues. “They’ve formed new lobbying groups, the FIA and the new European-based FIA subsidiary that brought in [ex-Getco executive] Mark Spanbroek. They’re getting the right people involved and putting the right firms in place—but are still in catch-up mode right now. So no, they’ve not had enough of a voice in the regulatory measures that are going on currently, but the good news is that they’re putting that in place today. They will have to do some pretty fast running to catch up though.”

There are other issues to consider, however, when looking at the actions of regulators—such as external pressures, issues of definition between high-speed and high-frequency trading, and also politics. “You do get very emotional statements about whether these people are speculators,” explains Chris Pickles, head of industry initiatives at BT, who also agrees that engagement from traders is key to the process. “Investment firms have been trying to explain to regulators what this is about, and regulators themselves are therefore caught between two sides—on one side is the financial market participants and on the other is the governmental masses, who tell them which direction they should be going in. So getting that clarity first—and taking the time to explain to regulators what this is all about—is a critical factor for investment firms.”

Indecent Proposals
Creating a new regulatory framework in such a fast-paced, uncertain and sophisticated environment as HFT has an intrinsic contingency for hazard. It doesn’t help that, although it’s been around for many years, the practice is now under the public spotlight. Andrew Haldane of the Bank of England delivered a speech recently at the International Economic Association’s 16th World Congress in Beijing and proposed that speed limits be put in place to minimize the impact of HFT on already volatile markets, arguing that efficiency needs to be matched up against stability.

“In calibrating this trade-off, a judgment would need to be made on the social value of split-second trading and liquidity provision, and whether this more than counterbalances the greater market uncertainty it potentially engenders,” he said during his speech. “At times, the efficiency of financial markets and their systemic resilience need to be traded off. This may be one such moment. Historically, the regulatory skew has been heavily towards the efficiency objective. Given today’s trading topology, it may be time for that to change.”

The idea of such speed limits concerns Louis Lovas, director of solutions at OneMarketData, who argues that such a provision essentially amounts to a latency tax, which is inappropriate given that competition between HFTs is measured in nanoseconds. “To introduce any kind of trading control—time limits, speed controls, taxing the market in that way—when the margins are so slim anyway on high frequency is potentially damaging across the board for all participants,” he says.

Lovas is not alone in this view. Although Haldane’s argument garnered much in terms of press attention, it’s clear that in such a fast-paced world as high-frequency trading, it’s not an idea that is particularly palatable. “I don’t really see the rationale behind that,” says Harrell Smith, head of product strategy at Portware. “I’m not sure that is something the market needs. It is certainly workable from a technological standpoint, but it is not necessary, nor would it address any of the broader concerns that regulators have about market stability and or fairness.”

Other proposals that have already been submitted in regulatory reviews, such as Mifid II, have also come under fire. Chief among those is the idea that regulators will validate every algorithm employed in the markets, the thought being that catching rogue algorithms will increase market stability and prevent logic errors, feedback loops or semantic faults from occurring—such as those allegedly seen during the Flash Crash.

Reactions to this idea have ranged from polite denial of viability through to outright incredulity. “If you look at appropriate on one end, and unworkable on the other, that one is unworkable,” says Smith. “I simply don’t think that is something that the regulatory body will be able to take on. The sheer amount of work involved in combing through every single line of code for hundreds or thousands of complex algorithms, all of which are being constantly updated and tweaked, makes this a non-starter. There is really no way to efficiently implement this proposal.”

Slow and Steady
It goes without saying that regulatory bodies have an unenviable job. The public mood toward the financial sector is still about as bright as an oil slick, and political pressure to regulate quickly and prolifically is enormous— not to mention the sheer level of education and engagement that has to take place for such a task. Indeed, a lack of knowledge about the industry is a key concern, but not the only one.

“We’re talking about the Dodd–Frank Act: that’s a massive piece of regulation,” says Hegarty. “At 2,200 pages, it’s absolutely huge. A lot of people are looking at this as a way to solve all of the ills of the industry but, frankly, that’s a pretty naïve viewpoint and approach because a lot of the rules that have been put in place over many years have resulted in the unintended consequences we have today.

“We’re talking about broad, sweeping rules, and any time that you have that kind of volume and complexity—combined with the rules and legislation being written by people who don’t eat, breathe and sleep the financial markets every day, namely the folks inside Washington, Brussels and the regulators within the UK—then you’re going to experience some difficulties when it comes to converting the legislation into the actual rules.”

These points are key as it’s categorically undeniable that outside of technological advancement, regulatory holes were what made the explosion of HFT possible in the first place. Regulators, it seems, have something of an impossible task ahead of them: trying to close the barn doors after the horse has bolted.

Some proposals have already betrayed this mindset—such as attempting to incentivize HFT firms to continue to trade during periods of extreme volatility or forcing them to become market-makers, something that doesn’t necessarily chime with their nature as financial investment entities. It’s the slow and steady approach that needs to continue, according to FIX Protocol’s Adams. “The regulators have been conversant to ensure that they’re not jumping to conclusions,” he says.

“Stepping back slightly, if we look at the way the regulators reacted to the financial crisis—some jumped one way and some jumped the other with regards to banning short-selling, while some were criticized for jumping too quickly and others for jumping too slowly—what it all means is that when it comes to HFT, it would have been easy for the regulators to just come out and say ‘It’s bad, let’s ban it,’ or ‘Let’s do something about it,’ but actually they’ve been good in not doing that.”

As the consultation process is still underway, it’s unlikely that solid direction will come from the regulators at any point soon. Until it does, the high-frequency trading industry has little choice but to engage as loudly and strongly as it can, while the regulators do the same.