High frequency trading (HFT) has become an extremely polarizing issue, and there are two competing viewpoints: 1) HFT dramatically increases liquidity and efficiency, and is a very positive step in the evolution of our financial markets, or 2) HFT is a destabilizing force, existing only to line the pockets of large predatory institutions at the expense of the retail investor. (Read More: High-Frequency Trading: It's Worse Than You Thought)
As it turns out, both perspectives contain elements of truth.
The media has largely, and incorrectly, blamed
- Electronic Communication Networks (ECNs) and Exchanges
- Algorithmic trading
All four of these factors, especially faulty regulation and malfunctioning ECNs and exchanges, are responsible for the cracks in our market structure.
I propose these three steps towards restoring confidence in our markets:1) Repeal portions of Regulation NMS
Regulation National Market System (Reg NMS) is a set of laws passed in 2005 intended to reduce costs and promote fairness in the financial markets. A big part of the regulation was Rule 611, the Order Protection Rule, which essentially forces transactions to occur at the quotes on the inside market or, National Best Bid and Offer (NBBO). There have been two major unintended consequences of Rule 611: 1) “layering” of the order book and 2) the migration of order flow from so-called lit public markets to dark (non-public) markets. (Read More: Is Fed Making Life Tougher for High-Speed Traders?)
Knowledge of Rule 611 has allowed nefarious traders to manipulate stocks by layering the order book “outside” of the “inside market” or, tightest bid / offer spread. Large buy side firms are forced to unveil their intentions by first executing on the inside market, no matter the size of the bid or offer. Many HFT firms exploit this fact by layering the order book just outside of the inside market with large bids and offers that are never intended to be executed. For example, if there is a bid for 100 shares on the inside market, and then just below that price a bid for 20,000 shares, you have to hit the 100 share bid before you can move on to the 20,000 share bid. The tiny window following the execution of the first order gives ultra-fast algorithms a chance to pull that 20,000 share bid before it gets hit.
Largely because of Reg NMS, large institutions are increasingly getting filled at bad prices on large orders. These institutions are either testing the algorithmic world (which has caused more problems with faulty systems) or are choosing to take their order flow to “dark” markets from public or “lit” markets. Dark pools allow large institutions to trade blocks with each other without displaying the liquidity on public order books. Dark pool transactions are considered over-the-counter and represent exactly the type of market fragmentation Reg NMS was designed to fix.
Plain and simple, Rule 611 within Reg NMS should be repealed. The inability to pay through the inside market has removed any incentive to sit outside the inside market with a block of real liquidity.
2) Create an Order Cancellation Tax
As we discussed, the passage of Reg NMS has unintentionally made markets much less liquid and quotes much less reliable. The very regulation that was intended to promote fairness in the market has given rise to high quote cancellation rates (traders are given time to back away from firm quotes, legally). The order book is now filled with false bids and offers, and is not a true representation of buyers and sellers. In fact, after doing internal studies, we found that, more than 98% of the orders that appear on the book are cancelled.* In other words, 98% of all orders being sent to exchanges are being sent on a kind of fishing expedition and will likely not result in trades.