February 3, 2014

Beware of New Rules

Understanding the likely form of new rules-like Regulation SCI-is essential for traders and investment firms so they can prepare for their inevitable implementation.

By Amy Bard and Dan Nelson

Recent high-profile market disruptions-from the May 2010 flash crash to this summer's three-hour disruption in Nasdaq trading-have demonstrated structural weakness that is an unfortunate byproduct of the financial markets' rapid automation and the rise of alternative trading systems, dark pools and other off-exchange venues. While these disruptions are often popularly blamed on high-speed traders, U.S. regulators have recognized that the causes are far too complex to be attributed to any single group. Consequently, U.S. regulators, in contrast to their European colleagues, appear to be on the verge of implementing systemwide, principle-based rules that will ultimately impact the vast majority of market participants.

Whether it is the concern that "machines are taking over" or a worry about fundamental analysis no longer mattering, high-frequency trading has been the subject of intense public criticism over the last few years. In addition to blaming high-frequency traders for almost every market disruption, critics have suggested that HFT distorts the markets, creates "false" liquidity and fosters a multitiered marketplace with massive discrepancies in the speed of information dissemination and trade execution. Despite the public's fascination with it, the number of players in the HFT marketplace is quite small, and although HFT still accounts for a great deal of order volume-up to 50 percent by some estimates-that number has decreased over the last two years.

While some HFT outfits have engaged in questionable conduct, such as "spoofing" (rapidly placing and canceling orders for the sole purpose of creating the appearance of market activity) and certain types of "quote stuffing" (clogging data transmissions with erroneous orders), the vast majority of HFT companies operate within the existing regulatory framework. Unfortunately, the existing rules have not always kept pace. HFT computers can and, under the right circumstances, do send millions of trade instructions in fractions of a second. Even with increasing data transmission capabilities, these instructions can overwhelm automated trading systems. The crashes, freezes and market disruptions we've experienced are attributable to systemic problems (a failure of data transmission capabilities or human failure to properly test new trading algorithms) as much as they are to the participation of high-frequency traders. Ultimately, it is the interconnectedness and speed of the system itself that can allow actions by individual participants to develop into cascading failures.

With this realization firmly in mind, both U.S. and European regulators have signaled that they are on the verge of imposing new regulations. Initial indications, however, are that the approaches will be very different. The U.S. has embarked on a principle-based approach, with regulations focusing on the structural integrity of the markets as a whole, while Europe appears to be focusing first on specific perceived problem areas, such as HFT.