Although the Flash Crash of May 2010 rudely alerted us to possible issues with high-frequency trading, it still took regulators quite a long time to come to grips with it. They were wholly unprepared for the responsibility and lacked the technology and Wall Street-style budgets to tackle the highly profitable business.
Now it appears that the regulatory HFT ball has finally started to roll, nudged along by whistleblowers, hedge funds and a bestseller, Michael Lewis’ “Flash Boys: A Wall Street Revolt.” September was a particularly painful month for the HFT industry, and the list of woes just keeps on growing. Let’s take a look:
* First the Securities and Exchange Commission imposed a $16 million penalty against HFT firm Latour Trading LLC for mismanaging its capital buffer or “haircuts.” This was the SEC’s first enforcement action against an HFT firm.
* Then, a veteran hedge fund manager accused HFTs of destroying his firm, Rinehart Capital Partners, citing evidence of stock market penetration from as far away as South Korea.
* Next, three big law firms announced a plan to sue major U.S. stock exchanges for giving HFTs unfair advantages to the detriment of regular investors, using claims from high-speed whistleblower Haim Bodek of Decimus Capital Markets.
* Adding insult to injury, NYSE Euronext paid a $5 million penalty to the SEC for giving HFT customers a head start in trading information.
* Finally, KCG Holdings — the love child of almost-ruined-by-an-algo Knight Capital Group and HFT chief Getco — and dark-block-trading venue Liquidnet have had to lay off staff as business dwindles. KCG’s stock has lost almost 20 percent since late August, and the firm has laid off 4 percent of its workforce, blaming integration efficiencies and a diffident equities market. Liquidnet said in September that it would lay off 6 percent of its staff, citing challenging market conditions.
The writing is on the wall: Making money in HFT is no longer as easy as it once was. And as the market grows tougher, so do the regulators. The Financial Industry Regulatory Authority Inc. just proposed a new set of rules aiming to make trading firms more responsible for their algorithms’ behaviors. Part of SEC Chairman Mary Jo White’s new 13-step program is to make HFT and off-exchange trading (dark pools) more transparent. As regulators crack down on dark liquidity, HFTs are beginning to lose some of their most lucrative trading destinations. Dark pools account for some 17 percent of all trading on the $24 trillion U.S. stock market.
Allergic to Light?
Further, dark pools appear to be allergic to the light that is being beamed on them. Barclays dark-pool volumes plummeted after it was identified by New York’s attorney general Eric T. Schneiderman in June for allowing predatory HFT. Shortly thereafter, Credit Suisse, Deutsche Bank and UBS were drawn into dark-pool probes by regulators and authorities on both sides of the Atlantic.
Liquidnet had been dinged by the SEC earlier this year for using confidential customer trading information to market its services. About three years ago, the SEC took a million-dollar settlement off of Pipeline Trading Systems for misleading investors. Pipeline had billed itself as a big-block crossing network that didnt allow HFT players, but this was only part of the deception. Pipeline was funneling the majority of its customers’ orders through a trading company that it owned.
As other global regulators join the New York attorney general, the predatory HFT sharks in dark pools are heading for the exit. Liquidity is already suffering, and I predict that there will soon be some major consolidation of dark pools. Many will simply close.
I expect the same is happening with HFT firms. Knight Capital was an early poster child for how HFT can go wrong. When in August 2012 one of its ETF trading algorithms lost control, spinning away to losses of $440 million in less than an hour, it nearly bankrupted the firm. (It was then acquired by Getco to form KCG).
As Bill Harts, chief executive of HFT advocacy group Modern Markets Initiative, said during TABB Forum’s Great HFT Debate, you just have to ask this question: If I buy 1,000 shares, how many of those shares will be bought from an HFT firm? The answer to that question is simple and similar across most markets: about 400 shares,” he said, adding, “regardless of market center, HFT firms provide much of the liquidity helping investors buy and sell.”
I believe that once the “Flash Boys” furor dies down and regulators are more comfortable with HFT, it will be business as usual because HFT is a valuable tool in the quest for liquidity. Some of the dishonest behaviors will no longer be tolerated, and more monitoring and surveillance by clued-in authorities will grab fraudsters and rogue algos before they can move markets.
In the end, a little tea and sympathy is in order for the firms trying to make a living out of the oh-so-complicated market structure.
Dr. John Bates is chief marketing officer/business leader for big data analytics, cloud and industry solutions at Software AG.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
