Shapiro Not Too Swift About HFT
Mary Shapiro weighed in on high frequency trading again. Well, sort of:
The rules the SEC is contemplating are vague, but could involve fees on high volumes of order cancellations or a minimum time enforced for quotes. “While we haven’t landed on concrete things that we will do next,” Schapiro said, “all these ideas are live and subject for discussion within the agency.”
The WSJ has a little more:
Among the ideas the agency is considering, she said, is the implementation of obligations for certain high-frequency traders to provide quotes near the national best bid and offer prices—the highest buy and lowest sell orders across the market—during a certain percentage of the trading day.
The SEC also is weighing imposing fees on order cancellations, which constitute “a vast majority of orders” submitted by high-frequency firms, Ms. Schapiro said. An estimated 95% to 98% of orders submitted by high-speed traders are canceled as the firms rapidly react to shifts in prices across the stock market, according to Tabb Group, which tracks trends in electronic trading. The possible fee, previously mentioned in a joint advisory committee of the SEC and CFTC, would likely be a tiny fraction of a cent per canceled order, experts say.
Imposing obligations is not costless. Requiring people to quote when they don’t want to quote means that they will quote poorer prices. With respect to cancellations, yes, some abusive HFT strategies do allegedly involve quote stuffing followed by cancellations. But many salutary HFT strategies, including the cyber equivalent of scalping-market making-also involve large numbers of cancellations. Market makers are at risk of being picked off, or of trading at stale prices, and hence want to cancel orders, and perhaps submit new ones at different prices, when new information arrives. And in an electronic environment, new information arrives rapidly. Locals scalping in futures pits were only obligated to trade at their quotes “as long as their breath was warm” to limit their exposure to these problems: cancellations by HFT traders making markets serve the same purpose. Taxing cancellations could well impair these legitimate uses of cancellations more than the abusive ones, leading to less liquidity and costlier trading. This is a very blunt tool indeed.
The fundamental issue is that HFT is not one thing. There are a variety of HFT strategies, some of which are beneficial, others arguably opportunistic. Moreover, it is quite possible that a given HFT firm uses a variety of strategies, some of which are beneficial, some of which are opportunistic. The focus should be on trying to identify order submission patterns that are characteristic of opportunistic strategies, and those that are characteristic of beneficial ones (e.g., market making) and develop pricing or enforcement measures that are targeted at the abusive strategies. Meat axe approaches like taxing cancellations are indiscriminate, and risk doing far more harm than good.
Shapiro doesn’t inspire confidence when she says things like this:
Schapiro expressed concerns of her own Wednesday, lamenting the current volume of trading that is “unrelated to the fundamentals of the company that’s being traded.”
“It’s got very little to do with whether you think IBM’s got a great business plan and solid earnings growth in its future … and a lot more to do with what’s the minuscule aberrational price move that you can take advantage of because you’ve co-located your computer with the exchange and can jump on that in microseconds,” she said.
“And that worries me in some ways.”
There has always been trading unrelated to fundamentals, that has been technical in nature and focused on profiting from minuscule price moves. That’s what most market making is about. Indeed, the existence of that kind of trading produces the liquidity that facilitates long term trading. And there have always been time and space advantages in trading. Why do you think people paid hundreds of thousands, and sometimes millions, of dollars to be on the exchange floor? The views? The charming company? No. Because being on the floor gave you an edge.
Shapiro’s testimony suggests that the SEC is befuddled by HFT. This is understandable, because there’s a lot about it that is not well understood, and because it is surrounded in a fog of mystery and controversy. But her testimony also suggests a deep-seated suspicion of HFT, and preference for indiscriminating solutions that will throw the baby out with the bath.
Not too swift.
Right on, Prof! The SEC is a bastion of lawyering, not economics. And you see it at the very top of the organization. They gutted their economic analysis capacity during the 2000s (what little there was even then), and left in its place a few lawyers without any great understanding of what markets are or how they operate. And, they have a tendency to fall back to what they used to have some expertise in — specialist trading (cf your comments above re requiring HFT shops to quote as if they were specialists).
The SEC always has been overrated in peoples’ minds regarding their economic expertise and market savvy. In fact, they are (and have been) a clear and present danger to the functioning of markets as the 2000s so amply demonstrated. They do not understand, and hence distrust, markets. And the SEC’s prescriptive remedies have and will continue to do more harm than good when it comes to the efficient functioning of markets. They are particularly dangerous in electronic environments and in auction markets like commodities. However, given the general distrust (and lack of understanding) about markets generally in Washington, the only way the economy finds out about how destructive the SEC is is when their prescriptions become the law of the land and things go terribly wrong. Then we get these god-awful attempts are re-regulating. And the call goes out to round up the usual suspects once again.
Comment by markets.aurelius — February 26, 2012 @ 9:26 am
@markets-2 stories apropos to your point.
1. A former colleague interviewed for the head economist job at the SEC in the 1980s. He met with the chief of enforcement (or maybe it was head of market reg) who told him: “I don’t care what you do, just stay the f*ck out of my way.” Obvious message: this is a lawyers’ shop, and we don’t need any steenkin’ economics, and I will crush you if you bring up any economics that is inconvenient to my agenda.
2. Not related to the SEC, but this CFTC story illustrates the same point. Wendy Gramm, an economist, was head of the CFTC under Bush I, and she attempted to bring better economics into the agency’s decision making. After Clinton won in ’92, Phillip McBride Johnson, a former CFTC chair and high powered lawyer, said (I quote from memory) “Now we can get rid of the economists and put the lawyers back in charge.” (I recall reading this in Futures Magazine. Don’t have ready access to it right now.)
The lawyer dominance-and correlated economic ignorance-is certainly the case today. And it is getting worse by the day.
Agree with you completely re the SEC and Ms. Shapiro, also with Markets Aurelius: these are blunt tools indeed and will almost invariably be handled badly. If these SEC, ahem, “thoughts” become law or reg, the one law that will apply is the law of unintended consequences.
MA – the SEC also screwed up the market in the 1970’s and 1980’s, big time.
Both of you have much more experience in markets than I, and more recent experience to boot, but I would like to mention two thoughts:
1. Products and trading strategies can be designed to make the market less efficient
2. Dealer Markets without centralized reporting and tracing order flow have their own set of problems.
The best example of the first was the creation and of the CMO, which initially did lower some rates on mortgages due to demand, but rapidly morphed. I used to ask trainees in pricing why CMO’s existed. The response was that a CMO took Mortgages and MBS and divided their cash flows so that pieces would be more attractive to different investors, blah, blah, blah. After 60 seconds of this I would interrupt and say, no that it how they are sold, not why they existed. The true answer was that sometimes CMO’s did create arbitrage profits, but mostly they took securities (MBS pools) where the inside market as 1-2 ticks or less and turned them into securities where the inside market was 4 ticks to 2 points ( if not more). at the end of the height of Agency CMO issuance, Bear was producing these 40-50 tranche nightmare deals that no one but they could really understand. this sin was repeated in RMBS in 2004-2007, but losses were so great that the garbage (high spread) tranches were wiped out, but the boys did try to keep the game rolling! I may be wrong, but I can see a lot of guys sitting on both hands trying to think up strategies using HFT that widen the effective spread that other investors face.
The general guideline from the above is that any strategy that widens the effective spread in the market – that is the spread the final (EOD?) investor, really faces, should be eliminated. How one would do that in the HFT world is beyond me, but I think it can be done.
Which leads to the second point. Back in the 1970’s I remember a raucous public debate about the dealer system vs. the specialist system, which ended up with one expert finally saying, yes, the dealer system might in theory be more efficient, but he would hate to see the kind of nonsense that went on in the Treasury market in Stocks. As another old timer put it it, is better to have one set of thieves you can watch, referring to the specialists, than 50 you can’t see. I am not sure I agreed with them, but it is a point to ponder.
I guess I am saying that there needs to be in place both a consolidated chronological tape and consolidated chronological order history. To my knowledge the former doesn’t fully exist and the latter is no where to be found. If this is in place, algorithms can be sued to identify abusive practices, whatever they may be.
Comment by sotos — February 26, 2012 @ 10:16 am