As the New York Times reports, other countries are leading the way to implement new regulations on high-frequency electronic trading while regulators in the U.S. have been “slow to act.” In my view, that may not be such a bad thing.
High-frequency trading (HFT) refers to algorithm-driven, computerized strategies that allow traders to move from one position to another in mere seconds, though often in microseconds. HFT traders make a profit from a “flash trade” by capturing the small fluctuations in price. HFT is often associated with equity markets, but it’s also used in commodities and futures markets.
In recent years, HFT has gone from being the darling of financial markets to the target of regulating bodies around the world, particularly after several high-profile U.S. market glitches (e.g., the Flash Crash in 2010 and Knight Capital’s trading snafu in 2012). Taking the helm in the overhaul of this industry are countries like Australia, Canada, and Germany. The overall goal: to avoid the U.S.’s major market screw-ups. The Australian Securities and Investment Commission, for example, announced a mandate that will force computerized trading firms to perform annual stress tests and obtain certification on their systems. In Germany, the government agreed to draft legislation that will require high-speed trading firms to register with the government and limit the speed at which they can place orders, a similar approach that a committee of the European Parliament agreed to adopt just a few days later.
The most far-reaching changes, as the NYT notes, have come from Canada, where regulators are imposing higher fees against firms that rapidly place and cancel large trade orders. Effective mid-October, a new rule will regulate the growth of private, non-displayed trading venues called “dark pools.”
The Securities and Exchange Commission, on the other hand, has announced no new rules over HFT this year. Moreover, the governmental remedies enacted thus far have been the band-aid type—emergency measures instituted to mitigate the damage already done. Still, it’s the SEC’s inactions rather than actions that have garnered the most criticism. Bloomberg Businessweek recently lamented how HFT “remains today as it was almost two years ago: an opaque, misunderstood, and almost totally unregulated industry.” To be sure, the government’s silence hasn’t made HFT any less of a prevalent issue: HFT currently makes up about 65% of all U.S. stock trading. And so, after two U.S. market collapses, HFT critics are now saying something’s got to give.
However, is speedy reform to high-speed traders the answer? I should think not. The NYT offers various explanations for the SEC’s slow response, such as the massive undertaking of Dodd-Frank and the significant force of market participants in blocking off new regulation. Yet another reason for the SEC to rightfully proceed with caution is enormous task of understanding the complexity behind and impact of HFT technology itself. Firms using HFT develop their own propriety algorithms and models, frustrating potential efforts to somehow uniformly monitor these systems. HFT technology has also created, along with harmful systems, an efficient trading environment benefiting not only sophisticated investors but also the investment funds and banks that manage the portfolios of many average investors. The other commonly-cited benefits of HFT technology are lowering trading costs, increasing market liquidity, and reducing the market price discrepancies between related products. Thus, re-shaping the automation that now drives financial markets has long-term consequences not only for the guys on Wall Street but also for individual investors on Main Street.
So far the ideas for reform run the gamut, from outright bans to speed limits on trading to taxes on transaction costs. But before any regulation goes into effect, the major threshold issue for the SEC to address is just how wide of a net it wants to cast with HFT reform. Should regulation target only HFT firms like in Australia, or should any online brokerage firm be under scrutiny for using some type of high-speed trading platform? The recently held market technology roundtable discussion, hosted by the SEC, is a step in the right direction if only to better equip the agency to understand the interconnectedness of the markets brought on by HFT algorithms and make a holistic recommendation going forward.
While it’s unclear how this industry will evolve in two more years, it’s certain that more government regulation will come. After the Knight Capital fiasco in August, the SEC announced that it would “propose a rule to require exchanges and other market centers to have specific programs in place to ensure the capacity and integrity of their systems.” Indeed, other countries have progressed farther in HFT reform. But if what’s really at stake is at the heart of our economic health—the average investor’s confidence in our financial markets—it’s worth taking the extra time to get it right.
For more views on how to reform HFT, see the NYT’s Room for Debate section.