High-Frequency Traders Face Speed Limits
High-frequency traders are facing "speed limits" for the first time on a major trading platform, under a proposal that is being touted as a template for a regulatory clampdown on computer-driven activity.
EBS, one of the two dominant trading platforms in the foreign exchange market, is suggesting scrapping the principle of "first in, first out" trading, which it says gives an unfair advantage to the fastest computers and has led to an arms race of spending on technology.
Instead, under the plan, incoming orders would be batched together and dealt with in a random order.
"It is a technology arms race to the bottom, and a huge tax on the industry, since people are having to make significant investments in speed without any connection to their trading strategy," said Gil Mandelzis, EBS chief executive. "Speed has little to do with why many participants come to our markets. These are serious players who come to the market to exchange risk; they do not come to race."
High-frequency trading, or HFT, has triggered controversy across financial markets, with many large investors complaining that it has increased the complexity of doing business.
Algorithms compete for microsecond advantages to get to the top of the trading book, and even the physical position of computer servers can make a difference because of the time it takes for orders to reach exchanges. Proponents argue HFT improves the efficiency of markets and narrows transaction costs.
EBS, a division of ICAP, the UK-listed interdealer broker, and Thomson Reuters run the two most popular electronic trading platforms in the $4tn-a-day foreign exchange market.
EBS will begin consulting on its proposal with users in the next week. It is likely to suggest batching incoming orders every few milliseconds, and rolling out the new system slowly across different currencies.
A third platform, ParFX, launched this month, uses a similar system to impose randomised pauses on incoming orders, saying it will ensure "a fair trading system for all". The company behind ParFX was created two years ago by large banks, including Deutsche Bank and Barclays, which said that EBS then favoured HFT firms.
Larry Harris, a former chief economist of the Securities and Exchange Commission and now professor of finance at the USC Marshall School of Business, who has been arguing for a similar speed limit in the equity market, said he hoped that its adoption in foreign exchange would spur regulators to act.
Since the "flash crash" of 2010, the SEC has been looking at the role of HFT in equities. The Commodity Futures Trading Commission is examining its potential impact in the derivatives markets.
Regulators in Australia and Europe have suggested "resting periods" of several hundreds of milliseconds to slow down trading.
"Wherever you see high-frequency trading, requiring a delay is a sensible thing to do," Professor Harris said. "We are talking about delays of one-thirteenth of the time it takes to bat your eye. It hardly slows down the market at all, but it ensures that a smaller trader has a better chance of getting first in line."
Mr Mandelzis from EBS said he expected other markets to follow foreign exchange and set speed limits: "The first twenty years of algorithmic trading have added great transparency and led to the compression of spreads – all great things. But there is a line beyond which marginal speed and smaller trade sizes add no value and actually harm the markets. At some point we, the public markets across asset classes, crossed that line."
"The 'first in, first out' model sounds fair and plausible, but in modern public markets it implies 'winner takes all'."