Streetwise Professor

Jerry Dicolo of the WSJ has a piece on allegedly disruptive high frequency trading strategies that have been employed in the natural gas futures markets immediately surrounding the release of the weekly storage report.  Exactly what is going on here is hard to surmise, but what makes most sense to me is that the HFT traders at issue are gunning the stops.  That is, they are entering big orders to blow through the standing limit orders, moving prices, hoping to trigger buy stops (if they are buying) or sell stops if they are selling: the triggering of the stops creates the kind of short term momentum that the HFT traders can profit from by taking the other side of the stops.

Another example, as if one is needed, of the dangers of stops.

And it should be noted that gunning the stops is not the product of this newfangled electronic trading.  It happened on the floor with some frequency.  There are manipulation cases from the 1960s, if memory serves, related to gunning stops.

It’s also worth noting that there is exactly one data point in the story, August 16th.  It would be worthwhile to see if similarly allegedly anomalous price action took place prior to late-2006 when the market migrated to the screens.  I’m betting you could find more than one.

The article suggests that what is attracting HFT to the gas market is not the opportunity to play games for a few minutes once a week.  Instead, entry of HFT is being spurred by wide spreads in the gas market, as compared to equities.  HFT competition has narrowed spreads to virtually nothing in equities, so HFT traders are looking for markets with fatter margins.  Which is why they are moving into commodities:

High-frequency firms—whose activities can range from market-making on behalf of clients to trading for their own accounts—have wrung profits from the stock and other markets for years. But recently, their increased action in commodities, natural gas in particular, is spooking some veteran traders. That could leave the market reliant on computerized trading systems and potentially reduce liquidity when it is most needed.

“We can fight over fractions of a penny in stocks, or full pennies and more in natural gas,” said a programmer at a New York high-frequency trading fund.

Uhm, that’s the way markets are supposed to work.  Entry reduces prices and drives returns to just cover the cost of capital.  Which is exactly why some “veteran traders” are “spooked.”  They can’t compete against HFT.  Their oxen are being gored, just as traditional market makers’ oxen were gored in equities.

The new entrants may play shenanigans like gunning stops-but “veteran traders” did that too-another reason for “veterans” to resent HFT, for elbowing in on their racket.  Such shenanigans should be addressed by more targeted deterrents, rather than Euro-esque attempts to hamstring HFT.

I expect that spreads in natural gas, and commodities generally, will narrow as HFT technology and capital moves into those markets.  As for fears that this liquidity will dry up when it is needed most, again, this is not unique to electronic markets or HFT.  It is a feature of market making general.  Market makers reduce their supply of liquidity when they suspect order flow is toxic, or when risk is rising substantially.  It was so when market makers wore handle bar mustaches and button up shoes and stood in trading pits.  It will be so when market makers are co-located servers.  It’s inherent in the nature of market making, not in the technology.

So today, 12 October, 2012, is the day when many Frankendodd rules go into effect.  Swap dealer registration for instance: but not position limits!

Yes.  848 pages of legislation (or 2319 pages, depending on how you count)-where commas matter-that spawned thousands of pages of rules (over 9k as of July, and where commas will also matter) that will spawn thousands more pages of interpretations, no action letters, legal rulings, etc.  All in an attempt to re-engineer a devilishly complex, interconnected financial system.  A system that will not stand still, but which will change in response to the law and the regulations, thereby producing myriad unintended consequences.

I’m sure it will turn out just swell.  Timmy! and GiGi and their successors have everything under control.  They’re from the government and there to help you!  Trust them on this!  Don’t you worry your pretty little head over it.

JK.  In reality, Mickey Mouse (how appropriate) gives you a better idea of how things are likely to turn out.

I fearlessly predict that the next financial crisis will follow directly from Frankendodd. It is a monster, which like Frankenstein’s, will escape its master’s control and wreak havoc. Mark my words.

The Bank of Canada has decided that Canadian entities can meet their G-20 clearing obligations by clearing with international CCPs like LCH or CME.

The alternative-which was seriously considered, until fairly recently-was to require the formation of a domestic Canadian CCP through which Canadian financial institutions would be required to clear.  The Bank of Canada was leaning towards a “Canadian solution” because it believed that it could monitor such an institution more effectively, that a domestic CCP would insulate Canada from global financial shocks, and that it would be easier to provide C$ liquidity support to a domestic entity.

I co-authored a study for the Canadian Market Infrastructure Committee (CMIC) which argued that (a) these benefits were illusory because there would be C$ swaps traded by non-Canadian entities and non-Canadian entities would likely be important members of a Canadian CCP due to scale and scope economies, and (b) mandating clearing via a domestic CCP would dramatically increase collateral and liquidity costs of trading C$ swaps due to the fragmentation of netting sets (among other reasons).  As a result, I/CMIC recommended that Canadian banks, investment funds, and insurers be permitted to meet their G-20 obligations with an international clearer that could margin more efficiently.

It’s good to see that BoC acknowledged the force of these arguments, despite its initial preference for a domestic CCP.  Reason sometimes prevails.

I’m less enamored with BoC Deputy Director Timothy Lane’s argument that commodity trading firms (e.g., Cargill, Glencore, Vitol, Trafigura, Dreyfus) are systemically important.  Much more on that subject soon-it consumed much of my summer.  Hopefully he’s open to persuasion on this issue, as he was on the necessity of mandating the use of a domestic CCP for Canadian IRS.  But it would be gratuitous of me to make too much of a bother of the global commodity trading firm (“GCTF”) matter now.  So I say kudos to Mr. Lane, and the BoC, for setting priors aside; evaluating the arguments and evidence; and coming to the right choice (IMO) with respect to clearing of C$ swaps.

HFT is under continued assault, both in the press and from regulators and legislators.  Europe is taking the lead on this, and Mifid II will impose some restrictions on HFT.  The Germans are particularly hot on restricting it, and are proposing other measures as well.

One goal of these regulations is to increase liquidity, and to improve the quality of liquidity.  Perversely, however, certain of the regulations intended to have these effects will do the exact opposite.

In particular, as I’ve argued since soon after the Flash Crash when many of these ideas were first proposed, things like minimum resting times for limit orders will reduce liquidity and make sudden reductions of liquidity more likely precisely when order flows become more toxic.  Limit orders are like options granted by the market maker, and extending the lifetime of the option increases its cost-particularly during times of high volatility and high order flow toxicity.  If you increase the costs that market makers, including those using HFT strategies to make markets,  incur to quote, they will quote wider, they will quote less, and their quotes will become particularly wide and particularly scarce during periods of elevated uncertainty.

In other words: there is no free lunch.  You raise the costs of market making, and liquidity costs go up.  Period.

Larry Tabb makes the point quite well:

So what will happen? If we mandate longer time in force periods, lower cancellation ratios, and higher market maker participation rates, liquidity providers will just widen their spreads to compensate them for the greater risk.

Won’t this force real investors to come in and bid? They may, however investors don’t quote on both sides of a market. They either buy or sell and not both. So many more quoting investors would be needed to make up for fewer market makers and HFT.

But, will HFTs actually leave? Market makers may leave but high-speed traders probably won’t; they will just change their stripes. Liquidity providers will flip to liquidity takers. Given a speed advantage, if it no longer serves a high-speed trader’s purpose to provide liquidity, they can just as easily take it. And since market makers and quoting investors are locked into providing liquidity for at least 500 milliseconds, HFTs will be the first to pick off every stale quote. And with a half second quoting mandate, there will be plenty of stale quotes to go around.

This last point is particularly powerful.  The regulations will penalize liquidity suppliers not just directly, but indirectly, by actively encouraging predatory/opportunistic algorithmic/HFT strategies that look for and pounce on quotes that are stale and not reflective of current information because of the restrictions on the time quotes must be enforced, and on cancellation and participation ratios.  (Note: these last restrictions are likely to create some rather complex time dependencies that can create some unanticipated sources of instability.  A trader’s current quoting behavior will depend on his past cancellation and participation rates, not just on current market conditions.  That adds a complex new feedback to an already complex process.)

The elimination of tiered pricing (e.g., differential pricing for quote makers and quote takers) will also tend to reduce liquidity.  Why don’t exchanges have the incentive and the information to get that right?  They are much better incentivized and informed than regulators.

So as Larry indicates, the regulations will reduce liquidity by raising the cost of quoting directly, and indirectly as well by encouraging predators to feast on those brave enough to quote:

So let’s combine points. Market makers will leave, spreads will widen, investors will post quotes, but HFTs instead of posting will take quotes. With investors’ quotes being frozen, HFTs will just pick off those investors. And once these investors learn this game they will stop posting, and then there will be little incentive for anyone to post quotes as the value of the limit order option grows just as the compensation to the option poster falls.

But won’t HFTs run afoul of HFT rules, you ask. Not really, since many of these rules focus on liquidity posting and not liquidity taking. If you take liquidity, there is no need to post or cancel, so cancellation rates decline to zero, and time-in force rules become immaterial.

Great.

Mifid II will also restrict those scary dark pools, in particular by banning crossing networks.  Which, as Tabb notes, will expose those seeking liquidity to predatory HFT, and other predatory strategies that raise execution costs.  For dark pools exist precisely to reduce the execution costs of those who are uninformed liquidity demanders. They swim in a (dark) pool because they don’t want to swim with the sharks in the open waters of the public markets.   Mifid will deprive them of that safe harbor, with the predictable result that Larry describes:

If all of this comes to pass, spreads will widen, depth will evaporate and there will be fewer places to hide as broker dark pools will face restriction. And the life of the buy-side trader, instead of becoming easier, will become much harder. And who suffers? The people who always suffer: the investors.

In other words, the Sorcerer’s Apprentices are at it again.  They claim to work magic that will make investors’ lives easier, but will in fact unleash forces that will wreak havoc.  And, no doubt, they will use the resulting havoc as the justification for yet more magical regulatory spells.

Not all HFT is good.  Not all algorithmic trading is efficiency enhancing.  It would be worthwhile to explore ways of curbing the inefficient forms of computerized trading without harming good forms.  There is justification for some regulation that can reduce the likelihood and impact of bad algos.   Mifid II is unlikely to have these effects.  Indeed, in my opinion-and in Larry Tabb’s too-it will likely have the exact opposite effect, and will disproportionately damage the beneficial forms of computerized trading and off-exchange trading.

Like the old joke says.  The Euros want to fix computerized trading in the worst way.  And they are succeeding.

I had a chance to read Judge Wilkins’s decision in the position limits litigation on a flight over to London, where I am speaking on the impact of financial regulation, at a conference put on by Lloyds Bank.

There is virtually no economics in the opinion-it is a highly technical analysis of issues related to administrative procedure, statutory interpretation, and the like.  The perfect thing to read while trying to get sleepy as part of my jet lag management strategy.

How technical?  The placement of commas technical.

There are essentially two parts to the decision.  The first relates to § 6a(a)(1) of Frankendodd.  This part is straightforward.  Judge Wilkins ruled that it was unambiguous that the CFTC had to make a finding of the necessity of position limits.  It didn’t.  Back to the drawing board, GiGi.

The second part relates to sections 6a(a)(2), (a)(3) and (a)(5).  Here you have to get into the weeds.  These Judge Wilkins found to be ambiguous.  The ambiguity relates to the words “as appropriate,” as in:

Section 6a(a)(2)(A):

In accordance with the standards set forth in paragraph (1) of this subsection . . . the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person . . .

Section 6a(a)(3):

In establishing the limits required in paragraph (2), the Commission, as appropriate, shall set limits –

(A)on the number of positions that may be held by any person for the spot month, each other month, and the aggregate number of positions that may be held by any person for all months; and . . .  [Emphasis added.]

What Judge Wilkins could not determine unambiguously was whether “as appropriate” referred to the setting of limits at all, or the specific quantity of the limits.  The plaintiffs (ISDA and SIFMA) argued that the CFTC had to determine whether it was appropriate to set limits at all.  The CFTC argued that it had to set some limits, and Congress directed it to set the specific quantities appropriately.

This is where the commas come in.  I won’t bore you with the details, but if you are planning any intercontinental travel, I direct your attention to pp. 29-30 of the ruling.  You don’t have to thank me for easing your jet lag.

This matter of ambiguity turns out to be mightily important under the Chevron doctrine which determines whether a court need show deference to an agency’s decision.  And here the CFTC (and yes, I’m looking at you, Gary) is hoist on its own petard.

For the CFTC claimed that the language in the statute is NOT ambiguous.  Citing the Peter Pan (!) case, the Judge ruled that by claiming that the ambiguous wasn’t, the CFTC wasn’t owed any deference, and that there is precedent in his Circuit to vacate and remand the rule:

It is well-settled in this Circuit that “deference to an agency’s interpretation of a statute is not appropriate when the agency wrongly believes that interpretation is compelled by Congress.” Peter Pan, 471 F.3d at 1352, 1354 (internal quotation marks and citations omitted) (vacating and remanding agency decision because agency “premised its construction on the plain language of the statute, which it treated as unambiguous, and because we find that the statutory language is in fact ambiguous . . . .”).

Whoops.  By adamantly asserting that there was no ambiguity in the relevant sections of Frankendodd that the judge did find ambiguous, the CFTC lost any claim to deference.

Where do things go from here?  Probably a ping pong game, with the rule bouncing back between the agency and the courts.

Presumably the CFTC will stitch up some justification for a necessity finding, and go into a long disquisition to meet step two of the Chevron test:

“[I]t is incumbent upon the agency not to rest simply on its parsing of the statutory language. It must bring its experience and expertise to bear in light of competing interests at stake” to resolve the ambiguities in the statute.

I don’t know whether a justification of a necessity finding that is based on bad economics or bad (or no) empirical evidence is vulnerable to legal challenge.  I suspect it would be difficult for the plaintiffs to get the rule overturned because of a weak justification for the necessity finding.  I also suspect that CFTC will be able to pass the Chevron tests if it does recognize the ambiguity-which makes me wonder why they didn’t so recognize it at the outset.

My guess, therefore, is that the CFTC can, after yet more hearings, and comments, and time, correct what Judge Wilkins found wanting.  But that doesn’t mean that it’s out of the woods yet.  Not by a long shot.  For the plaintiffs made four additional challenges of the rule.  The judge did not feel it necessary to rule on these additional charges because he found sufficient grounds in the first to remand the rule back to the agency.

Notable among the additional grounds for challenging the rule is “Insufficient Evaluation of Costs and Benefits under 7 U.S.C. § 19(a).”  Will the CFTC stand pat on its existing cost-benefit analysis, which gives the word “perfunctory” new meaning?  Or will it feel obliged to gin up something better, given that the court was obviously not impressed with some of its other legal reasoning, and given that the SEC has lost a major case due to its failure to do a proper cost-benefit analysis?

The other challenges relate more to the specifics of the rules.

In brief, they have not yet begun to litigate (apologies to John Paul Jones).  The position limit rule has a long, long way to go before it becomes a reality.

This also raises the question of whether other Frankendodd-spawned rules will be challenged.  I’m guessing yes.  And there will be much rejoicing-among lawyers, anyways.

It is a good thing when bad rules are stopped.  The ongoing uncertainty pending definitive legal resolution is more problematic, however.  But that’s our reality, and will be for some time, on position limits, and other aspects of Frankendodd.

The title of my 2010 Regulation piece on CFTC position limits characterized the agency’s attitude as: “No Theory? No Evidence? No Problem!”  I had a problem with that attitude.  So did a couple of industry groups, ISDA and SIFMA, and they sued seeking to block imposition of the limits.  And Federal District Court Judge Robert Wilkens has a problem with it too.  He vacated the rule and remanded it to the agency for reconsideration, and granted the plaintiffs’ summary judgment motion against the rule.

The decision turned on whether the CFTC had to find that position limits were necessary to prevent and diminish excessive speculation.  The agency said no: it had no discretion, that Congress had mandated that it impose limits.  The plaintiffs said yes: the plain language of the statute requires the CFTC to make a finding that limits are necessary because speculation is excessive and is causing unwarranted fluctuations in prices.

The agency further argued that imposition of limits were mandatory, whereas plaintiffs pointed to statutory language saying that Congress had granted the authority to impose limits “as appropriate.”

The judge was quite firm in his findings regarding necessity:

The precise question, therefore, is whether the language of Section 6a(a)(1) clearly and unambiguously requires the Commission to make a finding of necessity prior to imposing position limits. The answer is yes.

But the plaintiffs’ victory was not so clearcut as has been portrayed in the initial reporting on the decision.  The judge noted that the two sides had unambiguous, but diametrically opposed interpretations of the statute.  The judge disagreed with both, finding the statute ambiguous:

In sum, although each party believes the statute is clear and unambiguous, their respective “plain readings” compel different results. Ultimately, however, this Court need not choose between the competing interpretations. As explained below, Section 6a is ambiguous as to the precise question at issue: whether the CFTC is required to find that position limits are necessary and appropriate prior to imposing them. Because the Position Limits Rule is based on the CFTC’s erroneous conclusion that the CEA is unambiguous on this issue, the Court “may neither defer to the agency’s construction nor endorse plaintiffs’ construction.” See Humane Soc’y of U.S. v. Kempthorne, 579 F. Supp. 2d 7, 15 (D.D.C. 2008). Instead, the Court must remand this rule to the agency.

As a result, he chose not to choose between the parties’ diametric interpretations.  So the rule will go back to the Commission.  Presumably it will make a finding of necessity based on some attempt to stitch together some empirical evidence on the adverse impact of speculation.  Presumably the plaintiffs will find this evidence unpersuasive (with good reason) and challenge the Commission’s finding, thereby setting up a further round of litigation.  The results of this litigation would presumably depend on what is a satisfactory basis for a finding of necessity by the Commission.  This seems to me to be a potentially far more contentious issue in which the courts may be more likely to defer to the agency’s discretion and judgment.

This decision does not address another challenge to the limits: that the CFTC failed to perform an adequate cost-benefit analysis as required by statute.  That’s another big issue that would require a more discriminating critique of the substance of the Commission’s analysis by the courts.

So this decision is not the end of position limits.  It is probably the end of the beginning, at best.

The concrete results in the short and medium term are beneficial, however.  A bad rule that has no firm grounding in good economic thinking or empirical evidence, and which would impose substantial costs on markets and market participants, will not go into effect next week as planned.  The Commission will be forced to confront these economic and empirical issues, and defend its judgments on these grounds: “Congress made me do it” will not suffice.

No doubt this process will be time consuming.  It will certainly extend well past the election, and depending on the outcome of the election the matter may become moot.  A Republican CFTC is much less likely to pursue position limits with the Javert-like intensity of a Gensler-led agency.  But even under a Democratic administration, the CFTC’s will to pursue position limits will be sorely tested.  It now faces a greater burden of providing some theory, and providing some evidence, or else it will continue to experience big problems in court.

A good day, a good result, but not a final one.  The position limit wars will continue, but the battlefield looks far different today than it did when Frankendodd lurched out of the castle on The Hill, and when the CFTC did what it perceived to be the monster’s bidding.

Meaning “High Frequency Blogging.”  Some quick takes on things that caught my eye.

1. Echoing my looking back, looking forward point (made in July) re Libor, lawyers are very nervous that changes in the rate setting mechanism will call existing contracts-with outstanding amounts in the mere hundreds of trillions-into question.  Yeah, it’s broken, but be damned careful how you fix it-especially if you expect those “fixes” to be retroactive, and affect existing contracts.  Unless you want to subsidize corporate litigators and wreak widespread economic havoc.
2. OTC derivatives rules may be delayed due to “squabbling” among international regulators.  What a shock.  I mean, Carnac the Magnificent couldn’t have seen that coming.
3. The White House is backing off on its claims that the Mohammed video is the sole cause of the assaults on US diplomatic facilities throughout the Middle East.  On 9/11/12.  Jay Carney has a new explanation: an absence of gun control.  Seriously.  When asked about the attack on the US Consulate in Benghazi in which US ambassador Stevens was killed, Carney said: There is an abundance of weapons, including heavy weapons, and there are certainly groups that carry those weapons and look to take advantage of those circumstances—as there are around the region and the world.”  So, on 9/11, some heavily armed dudes were just walking around and decided: “Hey.  Let’s attack something.  Eenie, meenie, meiny, mo [NOT referring to Mohammed, mind you]-The American Consulate!”  Totally random.  Totally.  Not anti-US.  Not at all.
4. The Taliban attack on a US airbase in Afghanistan that destroyed six USMC AV-6 Harriers was a total clusterf*ck.  But O didn’t let that interrupt Jay-Z, Letterman, etc.  Priorities.  Have to have priorities, dontcha know.
5. This piece on China’s Solyndra Economy echoes several points I made in my earlier post recommending that we lose any competition with China on green energy technology.
6. The very excellent Michael Pettis rightly points out dangers for commodities emanating from China’s fraught economic condition.  Like me, Michael is somewhat amazed that people who would decry central planning and heavy handed government efforts to direct the allocation of capital in the US or Europe are in awe of Chinese genius in using central planning and heavy handed government efforts to direct the allocation of capital in China.  This will not end well.  Yeah, I’ve been saying that for a while, but I am convinced that in a few years (if not sooner) China will wish to have Japan’s problems.
7. Finally, to that point, consider the fact that large quantities of inventories of steel in China-allegedly in China, I should say-don’t exist.  And if it happens in steel, it can happen in copper or soybeans or whatever, and likely does.  Phony warehouse receipts have been used to collateralize billions of loans-or the same warehouse receipts have been used to collateralize billions in loans.  Either way, China’s shadow banking system-which depends heavily on loans collateralized by commodities inventory-arguably is far more shadow than bank.  Remember that even modest slowdowns in economic activity can unravel fraud schemes in a hurry.  Such a slowdown is happening in China right now, and it is extremely likely that numerous such frauds will be revealed.  Given the dependence of China on shadow banking, the consequences of this could be seismic.  What say you, Tooltime Tom Friedman?

And on that happy note, I am pulling the kill switch on this HFB experiment.

The regulatory and trading world is all up in arms over the big price drop in WTI, Brent, HO and RBOB on Monday. Fat finger? Runaway algo? Round up the usual suspects!

I say none of the above, especially in light of yesterday’s  story that Saudi Arabia is going to increase oil output.

The price pattern is not typical of a liquidity event, such as arises from a trading or algo error.  In such an event, the price usually retraces quickly to its pre-error level.  That is, price impacts are almost purely transitory if it is understood that the order was an error, or simply a demand for liquidity.  Indeed, a paper by Bayuksahin, Haigh and Harris documents that prices of trades subsequently identified by the exchange as errors reverse well before the official announcement: the market participants figure it out on their own.

Here, the price fell dramatically, then only partially recovered.  Thus, there was a persistent/permanent component to the price move.  This combination of temporary and persistent price impacts means that market participants viewed that there was some likelihood that the order/orders was/were submitted by somebody with private information. (The fact that the move occurred on all major energy markets simultaneously supports that view, although with algorithmic trading one cannot be as confident: one can be more confident it wasn’t 4 or 5 fat human fingers.)

Put that together with yesterday’s Saudi announcement (into which they were probably dragooned by a threat from the IEA and the administration to tap the SPR) and the most likely explanation is that the announcement was leaked, or that the individual or individuals behind the decision decided to make a little money on their information and control.  Which they did, because prices traded off more after the story was released publicly.

Therefore, IMO Monday’s event was an oil leak: somebody spilled the news of the Saudi decision, and that triggered a big trade that pushed down prices.

Not a tech issue.  Just old fashioned front running of an announcement.

According to this Greg Meyer piece in the FT, Barclays estimates that $6 billion have flowed out of commodity index investments in 2012, and that many institutional investors are reducing exposure to commodities.

The anti-speculation frenzy that reached a peak in 2008, but has never gone away, is predicated on the belief that index investing-“massive passives” in the words of CFTC Commissioner Bart Chilton-exert a disproportionate influence on prices.  So, this outflow of indexing money should have led to a decline in commodity prices right?  But they have been up over 2012: one broad index, the UBS Bloomberg CMCI is up from 1520 at the end of 2011 to 1628 today, about a 7 percent increase.

But the anti-speculation folks have their story, and they’re sticking with it.  Sayeth Dennis Kelleher of “Better Markets”, “There’s excessive speculation in commodity markets which is driving up prices.”  QED.

Evidence? We don’t need no steekin’ evidence.

Ironically, I am in NY to speak at the CME Group’s First Annual Global Commodity Investment Roundtable, an event aimed precisely at fund managers, where I will be on a panel discussing the role of speculation.  Greg’s article tees that up very nicely.

I’ve written about there being good HFT and bad HFT; HFT that enhances liquidity, and HFT that is predatory and attempts to exploit liquidity demanders (especially large traders).  Moreover, algorithmic trading (which may or may not be HFT, properly speaking) can potentially disrupt markets (e.g., the Knight Capital fiasco some weeks ago).

The question is: whatcha gonna do about the bad?  The knee-jerk response of many is to demand greater government regulation.  I have pointed out repeatedly, however, that this is an area where self-regulation is highly likely to be more efficient.  In particular, exchanges and other trading platforms have an incentive to design pricing structures and rules so as to reduce predatory trading, by HFT shops and others.  Predatory trading increases other market users’ trading costs, which reduces the derived demand for exchange services, thereby reducing the price the exchange can charge and the quantity of trading done on it.  Similarly, exchanges are hurt by disruptions caused by bad algos.

I’ve written a few posts on exchanges that have introduced pricing policies (e.g., charging high prices for “excessive” cancellations) with the specific purpose of reducing opportunistic trading.

Here is another example, this time from Forex:

Foreign exchange brokers are backing a series of changes unveiled by EBS, the world’s largest currency platform, designed to discourage predatory practices by high-frequency traders.

EBS, owned by interdealer broker ICAP, plans to widen the price spreads on its platform, raise targets on quote-to-buy ratios and set new quoting guidelines for Asian markets to discourage investors who exploit delays in technology to make money.

. . . .

Mr Mandelzis said that, while the changes were technical, they were aimed at encouraging genuine liquidity and discouraging disruptive behaviour, such as arbitraging prices.

With respect to dealing with the risk of runaway algos, CME and NYSE LIFFE are installing a kill switch functionality that permits FCMs to halt or limit trading activity by a malfunctioning algo:

Futures commissions merchants will be able to halt or limit trading activity at high speed on CME, operator of the world’s biggest futures exchange, and NYSE Liffe, one of the Europe’s dominant futures and options markets, if a computer begins to malfunction or a customer breaches risk limits.

Exchanges have an incentive to get these decisions right: they lose business if they basically provide hunting grounds for predatory HFTs or are unduly vulnerable to runaway algos.  Exchanges also have the information: they can observe what goes on on their systems, see who does what, and get feedback from customers.  Exchanges have a broad array of tools-outright bans on certain practices, and discriminating pricing policies. Exchanges are also able to move unilaterally and quickly.  In contrast, regulators have low powered incentives; poorer information; typically have blunt tools; and are less able to respond quickly and flexibly.  This is a clear case where self-regulation has advantages over government regulation.

This is particularly true in derivatives markets, where single platforms dominate a particular instrument.  Things may be more complex in equities, due to the potential spillovers across fragmented trading platforms.  But even there, the spillovers may be salutary.  A trading platform that clamps down (through pricing, for instance) on predatory arbs may push them to other platforms, but that just increases the incentive of those platforms to take action.  Moreover, different platforms have an incentive to compete to attract legitimate liquidity suppliers and liquidity demanders (especially the latter, since they are the ones that pay the freight), which means they have an incentive to compete to devise pricing schemes that penalize the predatory.

In brief, the task of reducing predatory computerized trading strategies should be left primarily to exchanges.  Predation will not disappear: it is almost never efficient to eliminate opportunistic/predatory conduct completely (because this would be too costly, primarily due to the fact that eliminating predatory conduct would almost certainly reduce some beneficial conduct), but exchanges have the strongest incentive, the best information, the most discriminating tools, and the greatest flexibility.  There will be an arms race between exchanges and predatory traders, but there would also be an arms race between government regulators and such traders.  Exchanges can run the race more efficiently and effectively.  Leave it up to them.