Interesting to read the venerable Leo Melamed’s open letter in the FT this week on HFT and regulators. The CME’s chairman emeritus certainly makes a good point when he says that trying to stifle innovation is both wrong and inevitably doomed to failure, but I am not sure he’s completely right in a couple of areas. First, whilst it’s true that algorithmic or HFT players have indeed had the effect of narrowing spreads, this is not always the best thing for the trading community as tighter spreads are nearly always associated with smaller trade sizes. This is a particular problem for the institutional buy-sides wishing to trade in size. A colleague at one such buy-side firm compared HFT to a waiter who, rather than serve a meal in three sensible courses, insists on bringing it to you in small spoonfuls and stays at your table waiting for a tip before he will go back to the kitchen for your next morsel.
Also, I imagine that most regulators would see themselves as gamekeepers rather than poachers but this does help highlight the fundamental problem our industry faces. The minute you interfere in any ecosystem and try to protect one species or another you invariably invoke the law of unintended consequences. This is especially true in financial markets that are going through a rapid period of evolution driven by a technology-inspired natural selection process. The tendency then is to try and adjust for these consequences with yet more regulation and so the vicious cycle continues. This is confirmed by the fact that it was the regulators themselves that inadvertently fuelled the HFT boom by breaking up the national (natural?) monopolies of stock exchanges in the first place.
We begin 2012 much as we left 2011 with fear, uncertainty and doubt being the prevailing sentiments, so maybe regulators on both sides of the Atlantic should take a second look at their groaning inboxes. Perhaps a return to lighter touch regulation is the lesser of two evils. Why not let the natural evolution of financial markets play itself out. Of course, there will be individual winners and losers but the overall ecosystem will emerge stronger to the benefit of everybody who is either directly or indirectly affected by capital markets. The alternative will be ever-growing mountains of retrospective regulation that will be arbitraged, hidden behind or simply never understood.
Regarding your comment about smaller trade sizes: I’m not a trader but my impression is that trade size began falling a long time ago. In 2007 we published a table in our magazine showing trade size for E-mini S&P 500 as of a single day in Feb 2006. The avg trade size was 2 contracts, and more than half of the transactions were one-lot trades. So clearly a lot of people were using machines to execute their trades even then. Second point: tighter spreads certainly leads to smaller size at the best price, but shouldn’t we also consider resting orders one tick or two ticks away from best price? Wouldn’t it be more effective to measure the total cost to execute a large trade today, knowing that you might have to sweep the book, and then compare that to the cost to execute the same trade back in the day when spreads were wider? Going back to your analogy, maybe the buy-side guy is paying tips more frequently now than he used to, but has the total cost of the service risen?
Good perspective, Steve.
Any of us who believe that the judgments and interests of millions of sentient beings interacting commercially are superior to the ideas of a few regulators straining at gnats appreciate Mr. Melamed’s perspective.
But what he omits in arguing for HFT is that HFT is itself an adaptation to rules. Regulators disliked the power and profit-opportunity available to market-makers and deliberately regulated out spreads in securities markets. What do we have now? A massive sea of intermediaries engaged in high-frequency statistical arbitrage, obliterating the original purpose of the futures market that Mr. Melamed highlighted.
It’s almost laughable that what regulators created they now want to restrain. Well, why not get rid of the rules that created HFT’s advantage in the first place?
Fundamental principle of capital markets: Low spreads and complex rules will transform your marketplace into a statistical arbitrage paradise.
Simple solutions that makes markets fair for all: Remove regulated spreads. Disconnect markets, unless markets wish to connect themselves for competitive reasons. Don’t protect automated quotes.
Human beings capable of developing nanosecond trade-decision tools are also capable of defending themselves in a caveat emptor marketplace.
I realize that we’re talking about futures markets, and not all securities markets, including the equity markets that I know best. But the principles apply all the same.
How ironic is it that the SEC Act of 1933-34 as amended has as its primary purpose free and unimpeded markets, and what we’ve gotten in its wake is an impediment colossus.
TQ
Hi Steve,
Just read you latest post and thought your comments about the ‘ecosystem’ in the 2nd paragraph really hit the mark. The national regulators around the globe are in agreement that we need more stable, less risky, financial marketplace. But working individually they will invariably upset the current perceived balance between countries.
The U.S Volker Rule is a good example of this. Canadian banks that use US infrastructure, such as DTCC for clearing, are subject to this and are calling for new exemptions.
Ultimately, changes have to be made but the global consequences to national regulatory changes are a wait and see. Like a dropping a pebble into a pool to see what the ripples hit. But in this instance it’s like dropping Mt Everest into every ocean in the world.
Matt
Thanks for the feedback. I agree that trade sizes have been falling but it does seem that this has been accelerated through the introduction of multi market infrastructure. The real frustration for the buy-side is the inefficiency of having to trade multiple times over. In Europe this is made more painful by the fact that interoperability at a clearing level still has a way to go.