Streetwise Professor

July 6, 2011

Nuance? Me?

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 10:55 am

David at Deus ex Machiatto responded to my response to his post on HFT.  A brief surrebuttal, if I may.

First, regarding CLOBs.  I wrote in the Regulation piece “Thirty Years War” that I linked to in my reply that the SEC had a choice between mandating a CLOB, and an “information and linkages” approach, and chose the latter.  Its implementation of the information-and-links approach was flawed, however, because they didn’t go all the way: the limitation to top-of-book protection is the most obvious flaw.

Moreover, a linkage-based approach is problematic during periods of market stress.  Any tightly coupled system is prone to failure.  David mentions that a CLOB has a single off switch, but that coordinating a shut-down of  multiple linked markets is more difficult.  That’s definitely true.  Failures of linkages–which are prone to happen during periods of high traffic and high volatility–can propagate through a linked system in unpredictable, chaotic, and destructive ways.  All this argues for a CLOB.

But, linkages are inevitable even if all trading in a particular instrument (e.g., a particular stock) takes place on a single CLOB.  In equities, for instance, cash and futures and options and futures markets should be interrelated and interactive, but cannot be run through a single CLOB.  Thus, linkages between such markets are inevitable, these linkages can break, and this tightly coupled system is prone to destructive feedbacks during periods of market stress.  Now with the proliferation of cross-market/asset strategies, linkages are pervasive and there cannot be a true single off switch.

But this is not an artifact of computerization of the markets and HFT.  It was a problem in the Crash of ’87, for instance.  The years immediately following saw a lot of chin pulling about how to coordinate among interrelated markets.

With respect to dark markets, darkness is a mechanism for segmenting privately informed traders and those who are trading for reasons other than private information.  In the old days, with block markets, non-anonymity (counterparty transparency), reputation (“no bagging the street”), and repeat dealing were the mechanisms for doing this.  Similarly, payment for retail order flow and ex post evaluation of trading performance of various sources of order flow was a segmenting mechanism.  As long as you have some people that are trading for reasons other than private information, you will have mechanisms to help them signal their lack of information.  If you force dark markets to light up, you will see the evolution of a mechanism that performs the same functions.  As surely as the light follows the darkness.  Or something.

David and I will agree to disagree about forcing limits on order exposure.  My argument against a say 1 second minimum exposure time is based on the fact that quotes are like free options.  Forcibly extending time-in-force increases the cost of that option to the quoter.  This is especially the case during periods when order flow is toxic–as was clearly the case during the hours leading up to the Flash Crash–that cost can become appreciable.  Many quoters will decide not to quote or radically reduce size.

In other words, the supposed cure is likely to actually exacerbate the problem of liquidity supplier flight which was at the root of the Flash Crash.  Making something more expensive is not the way to get more of it.  Minimum exposure rules would raise dramatically liquidity supply costs during periods when order flow is toxic, so you will get even less liquidity then.

Remember on exchange floors the rule is that a quote is good only “as long as the breath is warm.”  That’s because locals wanted to limit the value of the options they were extending.

There’s no free lunch here.  If you impose a constraint, and the constraint binds–there is a cost associated with that.  Somebody is going to pay it.

The “warm breath” metaphor reminds me that many of the things you see in HFT have close analogies to floor trading.  Sharply limited quote exposure times is one.  Colocation gives HFT traders a time-and-space advantage like that that floor traders possessed.  Even flash trading has its parallels: it is just another time-space advantage for a subset of traders who specialize in liquidity supply.  (Though to the extent that flash trading is used primarily to exploit the lack of full book protection the analogy breaks down.)

I’m sure we haven’t reached the end of this discussion, but that’s all for now.  As the title of my Regulation piece suggested, these battles over market structure and trading rules have gone on a long, long time, and will continue for as long as asset and derivatives markets exist.

Print Friendly, PDF & Email

1 Comment »

  1. […] to my last post, TSP suggests My argument against a say 1 second minimum exposure time is based on the fact that quotes are like […]

    Pingback by Deus Ex Macchiato » How much is a very short term option worth? — July 6, 2011 @ 2:48 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress