The crazy ride
High frequency trading (HFT) has been around for some time. Martin Wheatley, former CEO of the UK Financial Conduct Authority (FCA), dates the first case of HFT back to not later than 1815, when Nathan Rothschild, employing a spy and messenger network he had thoroughly built all over Europe, was the first to be informed of the outcome of the Battle of Waterloo. Armed with that knowledge, he was then able to deceive his opponents and make major earnings on the London Stock Exchange.
Nowadays, computers have changed the game and fast horses have been replaced by fibre optics. Following the 2010 New York Exchange Flash Crash, HFT has made the headlines of financial newspapers, emerging as a controversial topic and dividing the opinions of financial analysts, tech experts, economists and, more recently, regulators. This is mainly due to the peculiar characteristics of such advanced technology, which have already been analysed here.
In a nutshell, the advantages that HFT firms have in relation to average investors are the volume, speed and profitability of their mechanisms. Non-HFT investors simply cannot possibly keep up the pace and compete with the amount of trading movements constantly generated by algorithms. However, with great powers come great responsibilities and the occurrence of the aforementioned flash crashes (e.g. 2010 Flash Crash, 2016 Pound Flash Crash), as well as daily mini-flash crashes, loopholes and the unscrupulous routine practice of market manipulation strategies (e.g. “quote stuffing” and “spoofing”) have raised the pressing issue of regulating the HFT market.
Figure 1: The 2016 British Pound Flash Crash (Source: Bloomberg)
Even more disturbingly, the inherent nature of HFT is essentially self-destructive, as its hyper-competitive character encourages a tech arms race, or in fact a speed race to the last nanosecond, which will result in a zero-sum game. Considering the obvious limitations of the laws of physics (i.e. speed of light), HFT will eventually hit a wall. When more actors will trade at imperceptibly different speeds, profitability will be squeezed to the last fraction of a penny.
Some experts believe that HFT logically represents the future of finance and may even have positive effects on the market by reducing short-term volatility and the transaction costs, while increasing liquidity and allowing for a wider participation. Other speak in not-so-favourable and acquiescent terms. Indeed, it appears that in turbulent times, HFT actually amplifies market volatility, thus erasing short-term advantages and curbing non-HFT investors’ confidence. Notably, financial journalist and author Michael Lewis has declared in his book Flash Boys that “the market is rigged”. Likewise, Joe Saluzzi, an expert on algorithmic trading, has even depicted today’s financial market as a parasite-host relationship, in which HFT algorithms are gradually infesting the exchanges and eroding profitability to the bone. Even Paul Krugman, the 2008 Nobel laureate in Economics, has questioned whether “devoting an ever-growing share of [society’s] resources to financial wheeling and dealing, while getting little or nothing in return” is beneficial for our financial infrastructure and society overall.
The question of whether on a balance of benefits and costs, HFT is a benign and even desirable force within the financial markets and for society overall has no easy answer. However, what is quite clear by now is that an unrestrained HFT environment is not, but regulation will need to eventually step in. The trick is to balance the need for regulation while allowing for benevolent and healthy innovation to develop in a free market framework. And that is where the headache starts.
When it comes to HFT, regulation must address three key issues: market fairness, market cleanliness and market resilience. Indeed, the impact of speed and volume inevitably rises issues of market fairness, given that a small minority of HFT firms possess an enormous (and unfair) advantage against the vast majority of average investors. Secondly, when it comes to market cleanliness, the opportunities for abusive behaviour (e.g. “quote stuffing” and “spoofing”) have consistently been promoted by an unregulated employment of this technology. Lastly, potential flash crash and loopholes scenarios are disastrous both for investors’ confidence and market resilience in general.
Regulating the HFT environment comes with a series of challenges, the first and foremost being the complexity of the subject. As a matter of fact, academics and experts in the field are still to this day even debating on a basic definition of HFT.
Furthermore, considering HFT’s cutting-edge nature and the fact that the speed of progress in this field is prodigious and hardly measurable, how can governments and regulators possibly keep pace with the innovation? Indeed, regulation is fundamentally reactive in nature. With HFT, more than in any other financial sector, there is a risk that freshly passed laws and regulations, may soon become obsolete and subject to deception.
MiFID II to the rescue?
While HFT did not fall within the scope of the Markets in Financial Instruments Directive I (MiFID I), some degree of regulation has been provided by the Market Abuse Regulation (MAR). MAR prohibits HFT activities which are not intended to result in the actual execution of a transaction, such as spoofing. Nonetheless, a more defined and structured approach was required and MiFID II has been designed, inter alia, to step in and address such need.
MiFID II will become binding as per 3 January 2018 and will introduce a new regulatory environment for the EU/EER financial sector. MiFID II’s approach to HFT is not new and can be said to be largely based on the ESMA Guidelines Systems and Controls in an Automated Trading Environment for Trading Platforms, Investment Firms and Competent Authorities. The objective of MiFID II is to effectively impose regulatory speed bumps, in order to reduce market volatility and the occurrence of flash crashes.
For the purposes of MiFID II, HFT is considered a subset of algorithmic trading (AT). As a matter of simplicity, I will only refer to HFT throughout the article. HFT is broadly defined as a technique which executes large amounts of transactions in seconds or fractions of a second by employing 1) infrastructure that is intended to minimise latencies such as co-location, proximity hosting or high speed direct electronic access; 2) no human intervention in order initiation, generation, routing or execution for individual trades or orders (i.e. system determination); 3) high message intraday rates which constitute orders, quotes or cancellations. In April 2016, the EU Commission has published a Delegated Regulation, qualifying high message intraday rates as the submission on average of at least two messages per second with respect to any single financial instrument traded on a trading venue or at least four messages per second with respect to all financial instruments traded on a trading venue.
HFT firms which fall under MiFID II’s definition will have to file for authorisation and notify both the national financial authority and the relevant trading venue, in order to engage in HFT activity. Importantly, national financial authorities will be able to request a description of the firm’s strategies, key compliance and risks controls, and trading limits. HFT firms will also be required to store time sequenced detailed records of their algorithmic trading systems and trading algorithms for at least five years. National financial authorities will be empowered to eventually request these records.
In order to reduce the possibility of flash crash scenarios, trading venues will also be subject to new conditions. Venues will need to impose both order-to-trade ratios and minimum tick sizes, with the aim of controlling the volatile noise produced by fraudulent HFT algorithms. Moreover, both venues and firms will be required to integrate harmonised circuit breakers systems (a.k.a. “kill switches”), which by halting trading for a pre-determined period of time will allow to mitigate the risks posed by rogue algorithms and the potential occurrence of loopholes and flash crashes.
Before being deployed on the market, new algorithms will have to be tested within non-live controlled environments and only gradually introduced into the market. Fulfilling all these requirements will be no easy task for trading venues and HFT firms, requiring them to develop reliable and effective IT and security departments which meet internationally established standards.
The EU Commission has described MiFID II as the “toughest” financial package in the world, and rightly so. Only time will tell whether MiFID II’s approach to HFT is proactive and flexible enough to deal with the regulatory challenges and economic risks presented by this revolutionary force pervading the financial sector.