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Louis Lovas
Louis Lovas
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Bridging the HFT Impasse

"Okay, so you've identified a problem, you've earned half your salary. When you have a solution, you'll have earned the other half."

This is an expression a former colleague would use during the many years we worked together building software. It was typically directed at someone who would rant over some challenging predicament that arose with no obvious corrective course of action. These are people who go out of their way to find roadblocks and other seemingly insurmountable concerns, but will not devise a solution as it's not part of their makeup. In the software business they're called the Release Prevention Team.

The analog in the markets are those who rail against high frequency trading (HFT), and see it as the root of all that ails the markets. The recent precipitous drop in the first two weeks of August had its detractors immediately laying blame on HFT for the sharp declines and whipsaw volatility. While HFT strategies take advantage of volatility, they are emotionless chunks of code. The typical high-frequency model is buying and selling in rapid fashion throughout the day but never overextending a position in any one direction and by the end of the day they're flat.

The Blame Game

Why it is that high-frequency trading fuels such a negative emotional response? The portrayal of HFT firms operating "in the shadows," as described in a recent New York Times article, beguiles the imagination. The sublime image of shadowy figures, mathematicians using super-secret computer technology conjuring up algorithms to steal away from innocent investors is a common portrait. The twin of sublime is fear. Casting HFT as the fearful antagonist is enough to elicit a predetermined judgment, and without empirical evidence guilty until proven innocent. The CFTC's campaigning Bart Chilton, has said, "...we need to cage the cheetahs," but under what pretense? Commissioner Chilton continues to fan the flames of fear, with a desire to inflict punishment where no crime has been committed.

Meanwhile, there is a direct corollary between the staggering debt problems in the European and US economies and the nervous tension experienced by traders. A tipping point such as Standard & Poor's downgrade of U.S. Treasury debt usually manifests itself as a period of extreme price volatility. These volatile periods have occurred for as long as there have been tradable markets and they will continue to occur as long as humans are involved. The human psyche riding a wave of collective irrational behavior as declines beget declines and bad news caused more bad news moved hordes of traders to defy logic which further exacerbated the market's drop. It was the emotional element that played a much bigger role in the steep declines of the dark days of August, as it has countless times in the past -- long before high-speed multi-core computers, co-location and low-latency networks were even invented. Arbitrage, momentum and other quantitative strategies silently observed and traded that day just as any other day and exited at their predetermined take profit/stop-loss positions completely sans emotion.

It's no surprise, however, that institutional investors are fearful and regulators have drawn a bead on HFT firms. These responses are deeply rooted in the May 6, 2010 flash crash. That event drew back the curtain to reveal the fragile nature of the liquidity supply feeding our markets. HFT firms as market makers never envisioned themselves as the lynchpin of market integrity, where traders and quants are responsible not only for the profitability of their firm but also share accountability for the orderly and fair operation of markets. Yet in the aggregate their influence and affect is obvious and so is all the attention of regulators.

Despite the economic facts, there remain ideological differences based on prejudged opinions that create an impasse between those for HFT and those against it. Rather than having the detractors continue to rail against HFT and the other side defend it, a better path is to concede and cooperate to a compromise.

In any negotiated compromise, both sides must first accept the evidence of the other and focus on solving one thing at a time. The HFT detractors should recognize that HFT is a mainstay of the industry generating well over 50 percent of the trade volume in US equities with more and more buy-side firms considering entering the fray and is not going away. Therefore, attempts to regulate it out of existence are futile and will damage all market participants and the supporting financial industry at large. HFT firms, on the other hand, must realize their collective influence as market makers is not trivial, and the market's integrity is in their hands. Willful withdrawal during liquidity droughts to save their own skin is crash-inducing and ultimately damaging to all participants and the economy.

Over the past year there have been numerous regulatory controls enacted to reduce the chance of another liquidity-starved crash. The elimination of stub quotes, the addition of circuit breaker trading halts, limit up/limit down price collars and more recently the market access rule (15c-35) instituting pre-trade risk checks. These preventative controls are necessary measures to ensure market quality and to keep rogue algo's in check, but they are not the solution to safeguard market integrity.

Calling a Truce

In chasing that elusive goal of market integrity recent talks of a HFT transaction tax and other regulatory controls is misguided. A better alternative is a single-minded focus to find solutions that influence behavior and provide incentives for liquidity provisioning. To that end, a CFTC advisory board has suggested a 'peak load' pricing model. This is designed to provide incentives for market markers to stay in market during volatile times by suggesting Exchanges offer increased rebates. If regulators aim their attention at this and other behavior-changing incentives it would result in many of the other fears simply falling by the wayside.

Who knows, we just may call them the Market Advocacy Team.

Louis Lovas is director of solutions and business development at OneMarketData, where he delivers solutions for quantitative research and high frequency trading systems.

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