SEC to crackdown on HFT?

I gave my first presentation for a while last week on capital markets and what’s top of mind. Here are the headlines of key areas of focus:

• High Frequency Trading (HFT)
• Dark Pools
• Best Execution
• Post-Trade Transparency
• Global Trading Platforms
• MiFID II

I’ll review these areas in more depth during the week, and start today by looking at High Frequency Trading.

As discussed frequently here, High Frequency Trading (HFT) is being investigated as the most likely cause of the flash crash:

• More Banking Statistics: Algo and High Frequency Trading
• Who's afraid of HFT, HFT, HFT?
• Revising MiFID and RegNMS for HFT
• The Return of the MiFIDs, 2010-2012+

But it all began back on May 6th when the markets went into major meltdown, with sudden peaks and troughs. Accenture were a good illustration of the issue, with their share price nose-diving from $41 to $0.01 in a few minutes. Some would say that’s about right, but obviously it’s not as Apple’s share price shot up to $100,000 in the same period. Some would say that’s about right too, but this market volatility and instability is obviously not right.

So far, the SEC has not come out and said what caused it. They’ve said what hasn’t caused it – it wasn’t fat fingers, terrorists, hackers or similar attacks – and they are narrowing down on the real cause: HFT.

The focus upon HFT is whether this creates both market instability and an unfair advantage. The answer imho is that of course it does. HFT means that only those with the tech budgets can get access to markets and arbitrage on a global basis. HFT also means that any order entering the markets can be seen before it is filled and the price bucked by orders that ask for a fill and get cancelled just as fast. This is illustrated well by the $2.3 million fine issued by the SEC this week to Trillium Trading (now Trillium Brokerage Services), a small American proprietary trading firm.

What did they do wrong? They used layering to make $575,000 over a three-month trading period.

“Layering involves traders entering multiple fictitious orders, which are then cancelled within seconds. The strategy is used to drive a stock price up or down, before using a real order to profit from the artificially inflated or depressed price.”

It is one of several high-frequency trading techniques such as ‘spoofing’, where traders express interest in a stock, to drive the price up or down, with no real interest in buying it. Such practices are widely believed to have been part of the cause of May 6th flash crash.

Between November 2006 and February 2007, Trillium Trading used layering in “at least 46,152 instances”, according to the settlement agreement published by the SEC.

And it’s not the only one to be caught causing gaming. From Reuters in August:

Infinium’s “algorithm was turned on at 2:26:28 p.m. (Eastern) on February 3, less than four minutes before NYMEX closed floor trading and settled oil prices. It immediately started uncontrollably buying oil futures, according to the documents, which include letters from Infinium's lawyer to the regulation unit of CME Group, and cite notes from a company developer.

“Infinium placed 2,000 to 3,000 orders per second before its flooded order router ‘choked’ and was ‘dead in the water’ a few seconds later, the developer's notes said. The algorithm was shut down five seconds after it was turned on.

“By then, the documents show, the firm had sent 4,612 ‘buy limit’ orders into the market. It quickly offset the position, mostly with large ‘block’ trades in the next few minutes, leaving it with a $1.03-million loss.

“Infinium's burst of buying and selling represented about 4 percent of average daily trading volume in the contract, and caused a brief 1.3 percent jump in oil prices, from $76.60 to $77.60, before settling at $76.98, Reuters data show. Trading volume spiked nearly eight-fold in less than a minute -- and the reverberations turned some heads.

“The next day, February 4, commodities traders struggled to explain a 5 percent plunge in oil prices, the biggest one-day drop in half a year. On February 5, crude fell further, to $71 a barrel, and volume touched a then-record high.”

This is one key area of focus for the regulators.

I’ll talk about some of the others tomorrow.

From today's FT: an Ode to HFT based upon the song Those Magnificent Men in their Flying Machines

Those magnificent men and their trading machines,
They trade up, diddly, up, up!
They trade down, diddly, down down!
They stuff lots of quotes, then they empty the screens,
With their up, diddly up, up!
And their down, diddly, down down!

Up! Down! Flashing around.
Pulling their quotes, at such speed they astound.
They’re, all, raking in green,
Those magnificent men and their trading machines!

They can trade upside down
with their feet in the air,
They don’t think of value,
they really don’t care.
Ben Graham he would think he had made a mistake,
To see those young men, and the profits they make!

Those magnificent men and their trading machines,
They trade up, diddly, up, up!
They trade down, diddly, down down!
They stuff lots of quotes,
then they empty the screens,
With their up, diddly up, up!
And their down, diddly, down down!

Up! Down! Flashing around.
Pulling their quotes, at such speed they astound.
They’re, all, raking in green,
Those magnificent men,
Those magnificent men,
Those magnificent men,
And their tra-ding ma-chines!

This is Part One in a Series of Posts on the Regulatory Agenda for Capital Markets:

• Part One: SEC to crackdown on HFT?
• Part Two: What was the cause of the 'flash crash'
• Part Three: Exactly what is and how big are 'dark pools'?
• Part Four: MiFID II - the post-trade agenda
• Part Five: Best Execution and Global Trading

These items also build upon a series of posts about the Deutsche Börse:

• If you can't afford the tech, get out of the market
• Circuit
  breakers on the Deutsche Börse
• Forget
  Frankfurt, I'm moving to Basildon