Streetwise Professor

April 29, 2013

EBS’s New Trading Protocol: No BS.

Filed under: Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 9:38 pm

There are all sorts of proposals out there to rein in HFT.  The Europeans in particular-and in particular, particular, the Germans-want to do so.

I’ve long argued that there is good HFT and bad HFT, and that trading platforms have an incentive and the information to adjust fee structures and trading protocols in order to mitigate the latter.  For example, some exchanges have cracked down on excessive cancellations or the entering and canceling of orders far away from the current inside market.

Today’s FT reports another example, and a rather dramatic one.  One of the biggest FX trading platforms, EBS, is jettisoning the venerable time priority (“first come-first served) system with continuous trading.  Instead, it will collect orders that arrive during a period lasting a few milliseconds, and then execute them in a batch.  Instead of a continuous market, it appears to be a high speed sequence of call markets.  This eliminates the advantage of getting your quote in a millisecond sooner than someone else.  Perhaps it will also deter forms of gaming, such as strategies that (allegedly) attempt to create and exploit latency.

Will it work?  Who knows?  But that’s the point.  Markets facilitate the process of discovery.  Market participants compete to find solutions to problems.  EBS has identified a problem, and are trying to fix it using a fairly innovative change to the matching process.  If they’re right that some kinds of HFT are detrimental to market performance (and thereby reduces the demand for to trade on the platform), and their replacement of continuous trading with high speed calls impedes this detrimental HFT without impeding the good kind, they’ll make money.  And others will likely imitate, or take the basic idea and try to improve on it.

Or maybe it won’t work as planned. In which case they can try something else, or lose business to a platform that devises a better protocol.  The point is that a trading platform identified a problem with HFT, and is doing something about it, on its own.

All of this is far superior to top-down, one-size-fits-all government mandated “solutions” that are driven by political economy considerations first, efficiency considerations second . . . or third . . . or Nth.  Trading platforms may not internalize all the costs and benefits of better trading rules and fee structures, but their information and incentives are far better than regulators or legislatures.  Between competition among HFT firms, and the efforts of trading platforms to optimize the demand for their services, it’s likely that HFT’s rough edges will be smoothed out.  And if trading platforms don’t adopt such measures, you have to doubt seriously whether there’s a problem in the first place.  Because if there is a problem, they’d be the ones in the best position to know, and the best position to fix it.

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  1. This kind of innovation happens in the FX market because it is outside sovereign jurisdictions, and rulemaking. I cannot imagine FrankenDodd or EMIR allowing private innovation in trading equities or commodities.

    Comment by scott — April 30, 2013 @ 12:47 am

  2. Professor, I have thought for some time whether the high level of cancellations is a good thing or bad thing. Sure, it increases traffic in the network and imposes higher costs on algo-traders. But I think there is a rational justification to it as well – this cost is what algo-traders incur in order to at least partially managing their volumetric risks. The thing is, with algo-trading, except when you submit Fill-and/or-kill type orders, you never know what position you will enter into – you submit order for one position and because it might get only partially filled you will get into another. Thus you are inherently exposed to volumetric risk. High levels of cancellations may frequently be a manifestation of reduction of this risk and if one takes it away from the traders they will be forced to increase the price of risk per unit volumetric risk in one intelligent or non-intelligent way or another.

    I am also not sure if moving from “price-time” order matching priority to “time-price” or “time-whatever” priority is a good idea or it solves any rational problem.

    I would suggest that in the actual marketplace there is a hierarchy of latency players. Let’s brand ultra-low latency (or ultra-high-frequency) traders as Layer 1. There are some 10-20 major players currently in this category and they have a hold in this market. Then come the next level of HFT players – call them Layer 2. And finally there is the Layer 3 and so on.

    From what I can discern from your narration of the news (unfortunately I do not have direct access to FT), the best this type of proposal can accomplish is to equate the players in each Layer and have them share the corresponding market share rather than compete for it. In doing so, if successful, the platform itself will become a market share distributing mechanism among the players of various categories -perhaps a rather unfair mechanism for those who are right at the cutoff between the different layers – because of the “rounding errors” some at the cutoff between the different layers will end up in the higher category and others in the lower. In my view this is not fair. But surely market participants will have the choice of utilizing this platform or another.

    Generally I don’t understand what the fuss about the latency is. There is no mystery in latency. The solution of this problem is directly proportional to the dollar-amount spent. I understand that that dollar-amount is not available to everyone and many of the traditional traders who have been in trading business their whole lives and this is perhaps the only thing they know how to do will be out of business – that is, unless they change or learn something new. In every aspect of life, even in mom and pop shops, life forces everyone to keep learning.

    I can also think of a dozen of other business which if I had the capital to launch I could or perhaps would benefit from but I don’t have it.

    Generational change takes place in any industry and there are always large layers of market participants which are unhappy or are hurt when it does. I am trying to visualize the sense of indignation that coachmen might’ve experienced or expressed when the automobiles became a mean of transportation rather than a manifestation of luxury. I can also visualize how they would’ve claimed how hazardous the automobiles are and how rapidly the fatalities will increase. And I am sure the fatalities increased. This is a natural evolution of history and a predictable reaction to it.

    The only case of history going back (in my lifetime) that I have witnessed is ayatollahs taking over in Iran. And in this sense the attempts of slowing markets down look to me as ayatollaism.

    On the other hand, as a matter of structural statement, I have don’t have whole a lot of sympathy for those who are currently disadvantaged just because of the latency game. I have no professional sympathy for order flow traders. I don’t think that the elimination of an entire category of middlemen is detrimental to the markets. To the contrary, I think it is good. And if one category of middlemen is replaced by another category of more sophisticated middlemen, so be it – especially that this new category is extracting smaller margin on a unit basis from its mediatorship.

    However I think that any conscious player in the market should have the low-latency capability today. And if many of the smaller players don’t have that capacity, they should consolidate or outsource as any industry does when market share concentration takes place – whether due to the dropping profit margins or rising operational cost (in financial services industry both take place currently).

    They will need this capability if not for monetizing it, at least to be competitive when being forced to liquidate their positions due to the periodic crashes that I believe we are going to keep witnessing as a manifestation of aggregated risks by the sovereigns which they are going to periodically transfer to the industry through a variety of regulatory acts – in essence manifesting expropriation of private property.

    If we were to conceptualize risk as a commodity which one can buy or sell, one can state that there is going to be more and more competition for buying and selling risk or simply transferring it, and as we proceed, more misbalance of supply of and demand for risk accompanied with nonlinear risk-aversion dynamics is going to become the way of future. And when the misbalance is brought to the forefront everybody is going to rush to be on the right side of the market but only the ones who are equipped to get there quickly are going to be able to. This is indeed an arms race driven by a scarce commodity when interpreted the right way.

    Therefore my thinking is – one should spend more today in order to be positioned to compete for this commodity or lose a lot more because of not being positioned.

    And in this sense, whether they put latency in buckets or not, what difference does it make?

    Comment by MJ — April 30, 2013 @ 2:19 am

  3. […] Full post from SWP here […]

    Pingback by EBS vs ParFX | — April 30, 2013 @ 2:39 am

  4. agree, the private sector ought to innovate, and figure this out. the regulators are way behind and can’t possibly solve anything. the cftc the way it is run today is archaic, and will regulate us out of business. They are doing more harm than good.

    Comment by Jeff — April 30, 2013 @ 9:57 am

  5. @MJ-I can also think of good reasons for high cancellation rates. More later.

    The ProfessorComment by The Professor — April 30, 2013 @ 1:03 pm

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