Are Exchange Order Fees the Best Way to Regulate High-Frequency Trading?
The viewpoints on high-frequency trading are all over the map. HFT firms strongly believe they are adding liquidity to the market while other market participants claim that certain HFT players hurt the marketplace.
This past summer, for instance, I spent several days with the senior management team of a high-frequency trading firm. The firm trades on more than 10 exchanges worldwide in several instrument categories, but it is an exchange member in only one case and is not a market maker. The firm closes its positions at the end of each trading day, taking on no risk overnight. Management believes that the firm provides exchanges with a valuable benefit, adding liquidity to many instruments and thus improving the efficiency of public markets.
By contrast, Thomas Peterffy, CEO of Interactive Brokers Group, argues that HFT firms damage U.S. markets. "Since they have low regulatory overhead, no market-making obligations and few restrictions on their trading, they are free to take market share from registered broker-dealer market makers in placid markets and then withdraw or disappear entirely in times of increased volatility or serious market breaks," he says. As reported by the Wall Street Journal in October, Peterffy proposed to the SEC that exchanges hold orders for one-tenth of a second, allowing only market makers to trade during the delay.
So how do regulators reconcile such opposing views? Do HFT firms add valuable liquidity, increase volatility in times of market stress or both? Even recent academic studies differ in their conclusions. So should regulators implement more stringent oversight of HFT than for other styles of trading?
The SEC already has taken several steps in response to the May 6, 2010, Flash Crash, including banning stub quotes and naked access and expanding circuit breakers. Regulators are considering the implementation of additional measures to further reduce the probability of another flash crash. In addition, FINRA has been inspecting the design specifications of HFT software at several firms, and evidently, in some cases, is even inspecting software code directly.
Weighing HFT Market Maker Obligations
It's important to note that Interactive Brokers CEO Peterffy's proposal to delay orders by a tenth of a second would roll back advances in trading technology. First-generation electronic matching systems introduced 20 years ago could process a simple order in about one second. Second-generation systems, implemented 10 to 15 years ago, could process orders in a tenth of a second. Five years ago, many exchange systems could process orders in a millisecond, or one-thousandth of a second. And the most recent generation of electronic matching systems can process an order in around 0.2 milliseconds (200 microseconds). Thus Peterffy is arguing that orders should be slowed down by a factor of 500.
Ironically, Peterffy and Interactive Brokers, a market maker, greatly benefited from the advances in trading technology. It has been a pioneer in accelerating trading automation and in trading on electronic exchanges. Now, however, other firms, some of which are not market makers, have invested sufficiently in technology to process orders and trades just as rapidly as Interactive Brokers. If regulators were to agree to Peterffy's proposal to artificially constrain trading technology, U.S. financial markets would be weakened and over time would lose business to more advanced markets.
Regulators could require that certain HFT firms act as market makers -- simultaneously make offers to buy and sell the same financial instrument. But implementation of this requirement would inevitably be subjective. What exactly constitutes HFT? What passed for HFT 10 years ago may only be medium- frequency trading today. And should HFT firms receive a benefit in return for this new obligation, similar to the time advantage given to traditional market makers?
Exchange Order Fees to the Rescue
Before the advent of electronic trading, exchanges in mature markets typically experienced a ratio of orders to trades of 3-to-1. Ten years ago, when electronic trading first became the predominant business model, the ratio increased to about 10-to-1. With the advent of HFT, that ratio now can reach 100-to-1 or higher.
But fees currently charged by exchanges reflect an earlier era. Look at the U.S. equities markets: Putting aside a few specialized exceptions, exchanges charge fees only for executed trades, not for orders. When the ratio of orders to trades was 3-to-1, that approach made sense. The incremental cost of processing the orders that did not become trades was small. Now that the ratio is much higher, though, the cost of building exchange infrastructure to handle so many orders is significant.
So why don't exchanges assess a fee for processing an order? Clearly, an exchange's ability to rapidly process high volumes of orders has economic value -- it is essential to the business models of many HFT firms. The reason is that there would be a first-mover disadvantage: The first exchange to assess a fee for orders would lose market share. And HFT has become a critical source of revenue for U.S. exchanges, accounting for more than 50 percent of trading on U.S. equities markets. Therefore, at the moment, financial firms (and indirectly, virtually all individual investors) with low order-to-trade ratios are subsidizing those firms that have high order-to-trade ratios.
If regulators were to encourage exchanges to charge a fee for orders above a certain threshold, the new policy would adjust the relative advantages and obligations of HFT firms and market makers. This adjustment of market structure would be simpler and more comprehensive than adding market-maker responsibilities to certain HFT firms.
HFT Is Neither Good nor Bad
Like many technological advances, HFT is neither inherently good nor bad. For intermediaries trying to profit from momentary inefficiencies in the market, the ability to trade quickly always has been an advantage. A leading objective of regulators should therefore be to ensure that all financial firms have fair access to exchanges, so that the ability to pursue HFT strategies is not limited to a subset of firms. And most important, competition should be maximized among exchanges, market makers, exchange members, and the customers of exchange members -- including, of course, HFT firms.
Bad actors existed before the advent of electronic trading, and bad actors surely must also exist in the era of high- frequency trading. Regulators should remain vigilant in protecting market integrity. However, vigorous competition will achieve the most uniform protection against HFT firms attempting to manipulate the market and also will lead to more efficient financial markets. Regulators have the resources to vet the software code of only a handful of trading firms. With limited resources, this course should be pursued only as a deterrent and a last resort.
Wayne Arden is an independent consultant, concentrating on financial technology and clean technology. Previously, he was VP of sales for Nasdaq OMX's Market Technology division in the Americas from 2003 to 2008, focusing on exchanges, alternative trading systems and clearinghouses.
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