Streetwise Professor

Free Exchange, one of the blogs at the Economist writes up one of my takedowns of the SPR release.

Deus ex Machiatto has an interesting post on high frequency trading.   His basic take:

I would argue that HFT has reduced trade sizes and decreased liquidity/increased costs for block trades, especially combined with the move to trading the VWAP rather than brokers taking on blocks as a risk trade, but (3) really gives me pause for thought. Is it true?

. . . .

My recipe for HFT is not to withdraw it, but to reduce the impact of its speed by (1) requiring all market participants to trade on a central order book – no dark pools and (2) requiring all quotes to be good for a minimum of half a second. This would affect real trading activity very little while completely wrecking the high frequency strategies that generate flash crash risk.

I am skeptical that requiring trading on a central order book (CLOB) will eliminate flash crashes.  Note that flash crashes have occurred on futures markets with CLOBs.  The eMini on 6 May 2010 is the most notable example, but even in markets without linkages to other markets–such as cocoa and natural gas–(a) have CLOBs, and (b) have experienced flash crashes.  I’m also skeptical that dark pools have anything to do with flash crashes, and am also not convinced that the dark pool structure–which as DEM notes, has effectively supplanted the block market for facilitating large trades–is detrimental to the interests of those who want to trade in size.  After all, a block positioner could still attempt to compete for the business of those who want to trade in blocks: the fact that dark pools have become the venue of choice suggests they outcompete the old way of trading blocks on cost.

That said, I have long been critical of the SEC rules that protect only the top of the book rather than the depth of book.  Top-of-book protection provides a way for HFTs to make money by exploiting fragmentation of liquidity.  Creating a real CLOB entails a whole set of issues (see the linked article above for a brief discussion), but these can be avoided through the creation of a virtual CLOB that protects the entire books of the various liquidity pools.

A related issue is flash quoting, in which the operator of a matching system gives those supplying liquidity on it a first chance to execute orders before they are routed to other venues.  This undermines time priority, which also precludes the creation of a virtual CLOB by integrating the books of multiple venues.  This can also affects the incentives to supply liquidity.

DEM also links to a presentation that notes that HFTs make money by collecting liquidity rebates.  He further quotes a Bank of Canada study:

Some HFT participants to overload exchanges with trade messaging activity; use their technological advantage to position themselves in front of incoming order flow, making it more difficult for participants to transact at posted prices; or withdraw activity during periods of pricing turbulence.

Both these issues relate to the subject of the very first substantive SWP post: exchange pricing.  That is, the prices that electronic exchanges charge their customers.  I wondered then, and I wonder now, why exchanges don’t charge users for causing congestion on their systems.  If quote stuffing and overloading is problematic, exchanges could penalize it through how they charge for message traffic.  You’d think they have the appropriate incentive to do so.  If it is parasitic on the customers who generate revenues for exchanges (because it is undertaken by those whom exchanges typically pay rebates–see below–and harms the people whom the exchanges charge positive prices), the exchanges would have a strong incentive to devise pricing strategies or quoting rules that would tend to deter this conduct.

Exchange pricing is also relevant for rebates.  It makes sense for exchanges to subsidize some activity (providing quotes) that increases the revenues they can realize from other activity (taking liquidity).  Again, exchanges should have the right incentives to balance the costs and benefits and come up with pricing schemes that encourage the right amount of liquidity supply.

It would certainly be odd, I should add, to want to discourage this kind of pricing if one of your concerns is the disappearance of liquidity.

And related to the disappearance of liquidity, I agree that contributes to crash risk–in both old school floor markets and newfangled electronic ones.  But restrictions on quoting–e.g., DEM’s suggestion that quotes be good for one second–could well be  counterproductive in that regard.  The current evidence suggests that order floor became much more toxic on 6 May 2010, and that’s why HFTs stopped supplying liquidity.  Forcing them to keep their quotes good for longer than they would choose to on their own in such circumstances makes it more likely they will not quote at all.  That is, establishing minimum times that quotes must be in effect is likely to accelerate the wholesale withdrawal of quotes altogether during circumstances in which flash crashes are most likely.

I think there are many issues implicated with HFT–not the least of which being whether there is even an approximate match between the social and private benefits of this activity.  Many of the issues associated with it, however, I think are only peripherally related to flash crashes.  HFT may have a role in flash crashes–though exactly what is hard to pin down, and it may also have a role in making them flashier, i.e., shorter.  But many of the controversies involving HFT don’t appear to be connected to flash crashes.  As in many issues involving financial infrastructure these days, many issues are getting mashed together.  This makes coherent analysis hard, and coherent responses even harder.

Bloomberg reports that much of the oil being sold out of the Strategic Petroleum Reserve is being put right into private storage. Which is exactly what the figures in this post showed would happen.  Indeed, the only thing that is preventing more oil from moving into private storage is the fact that market participants now anticipate that it is more likely that oil will be released in the SPR in the future, thereby reducing the returns to private storage.

I can’t believe those that made the decision to release the oil from the reserve didn’t anticipate this would happen.  Perhaps they didn’t estimate the magnitude properly, but that wouldn’t be surprising given that this depends in large part on how market participants expect the SPR will be used in the future.  If they actually thought all of the oil would be consumed over the next month, thereby causing prices to crater, they have no business making such decisions.

The best part of the article is the bonus description of the inane consequences of the Jones Act, which prevents the use foreign-flag vessels to ship oil between US ports.