Flash Trading: The informational age gone awry?

by Jarrett Szczesny October 24 2011, 10:05

Flash Trading: The informational age gone awry?

The historical purpose of the stock market, serving as a method for companies to affordably raise capital, is fading quickly. The proliferation of supercomputer trading algorithms and complex derivatives (e.g. Synthetic Collateralized Debt Obligations) has given rise to an age of increasingly complex trading methods. One of the foremost advances is the speed of trading, seen predominantly in high-frequency methods. The expansion of bandwidth and connection speeds has enabled traders to execute trades in as little as one-millionth of a second, a far cry from the historical telephone relays to traders in the pits. However, even with the public outcry for more transparency within the financial markets, little is known about the actual effect high frequency trading has on the markets and the everyday investor.

History

Computerized trading has existed in many forms for decades now, but the real expansion came in 1998 when the S.E.C. authorized electronic exchanges to compete with industry giants like the N.Y.S.E. However, this change did not immediately usher in an era of flash trading due to technological constraints. As technology advanced, so did specialized firms that coded algorithms to capitalize on specific inefficiencies or arbitrage opportunities within the market. The presence of high frequency traders has become so pronounced that the N.Y.S.E. is currently building their own data center to cater to them. Presently, these high-frequency traders account for roughly sixty percent of all shares traded in US stock markets and are a large reason that volume on the N.Y.S.E. is up 164% since 2005. It is clear from these facts that high frequency trading is not a here today, gone tomorrow trend.

One Method, Two Results

Although at first glance firms use similar tactics, they actually operate in different capacities based on how they position themselves. “Market Makers” attempt to make profits through the bid-ask spread, the difference between the buying and selling price of a security. These firms look not to profit from market aberrations, rather, they focus more on small profits from each security sold, hoping to make a miniscule profit on each share that is then magnified over the trading of millions of shares. The other tactic is considered “signal” trading. These firms write complex coded algorithms that exploit subtle inefficiencies in securities pricing or market fundamentals that may only exist for less than a second. Even if these inefficiencies result in a penny per stock profit, the immense speed of the computers allow them to trade in bundles of thousands and make significant profits in mere seconds. Even with these advantages, some firms have used other tactics such as flash trading to squeeze out profits in questionable ways.  

More Than a Speed Advantage 

With the ability to execute trades in nanoseconds, firms have incorporated methods such as “flash trading” to glean increased knowledge to capitalize on their speed capabilities.1  Flash trading is utilized by both signal and market making high frequency firms to obtain exclusive knowledge about upcoming market orders. It is a practice where traders submit a limit order to buy or sell a security. When this order is placed, the market center flashes the order to a limited number of other traders who can execute trades with their supercomputers in milliseconds before the open market even receives notice of the order.2 In order to obtain these advantages, high frequency traders pay exchanges such as Bats Global Markets for exclusive access to flash orders that they can trade on.3 In practice, a select few firms with the financial backing and trading capabilities are given a near monopoly on certain information before it reaches the general public. The methods used to exploit these advantages become increasingly complex, but at the crux of the matter is the informational inequality that results. At a point in time when average citizens question the integrity of financial institutions, it seems unique abilities like these merely exacerbate those fears.

The S.E.C. has recognized the potential abuses that can result from these practices and sought methods to curb the creation of a “two-tiered market”.  S.E.C. chairwoman, Mary L. Schapiro, pushed for the elimination of flash orders back in late 2009. It seems that her infuriation with the practice has not been significant enough because flash orders remain legal and are still being utilized. These open warnings about the dangers of flash trading, which later result in weak follow up, seem to be the norm considering the intertwined nature of high frequency trading and equity marketplaces. An impactful alteration in high frequency trading would drastically alter the volume on many exchanges, not to mention sending shockwaves throughout every financial market. It appears that the inability of the S.E.C. to address high frequency trading when it first grew into prominence has now handcuffed their regulation abilities. The precocious nature of global equity markets makes any drastic changes in trading procedures seem unlikely until a far greater level of stability is reached. 

Down, But Not Out

Although significant regulation alterations seem unlikely in the near future, the SEC has taken steps to temper the growth of these new practices.4 In an attempt to modernize U.S. markets and increase transparency, the SEC adopted Regulation NMS in 2005.5 The regulation included an Order Protection Rule “that governs access to limit orders and thus applies to flash orders.”6 The rule “requires that the best bids and offers… for an equity security be immediately displayed in all markets.”7 This rule would seemingly eliminate the split-second exclusivity created by flash orders. However, the rule “only applies to immediately accessible, automated quotations,” (italics original) a distinction that the market centers who offer flash trading seized upon.8 These centers argued that flash orders are in actuality not immediately accessible.9 Even SEC Associate Director David Shilman agreed with the market centers assessment stating, “The Commission’s view is that flash orders that are for a sub-second period of time are consistent with the quote rule which allows an exemption for orders that are accepted immediately.”10 So, even when the SEC passes regulation that could restrict the proliferation of these questionable tactics, they back down when actually forced to clarify their stance.  

Too Little Too Late

Even though the SEC has characterized flash trading and other similar practices as harming price discovery, increasing market volatility, and undermining public confidence, they still refuse to meet the problem head on.11 As a practically worthless concession to appease a fickle public, the SEC instituted the use of circuit breakers to temporarily halt trading if an index experiences too much fluctuation. This fluctuation is considered, in part, to be derived from the massive trades executed by high-frequency traders. Instead of actually regulating flash trading, the SEC has decided to merely institute stopgaps that will kick in when the system goes seriously awry.  The SEC has now proposed lowering the minimum threshold from 10 percent down to 7 percent and changing the index to represent a broader range of securities. While circuit breakers are certainly not an unwise practice, their value is only shown in extremely dire situations. The proposed 7 percent threshold would have been triggered only 10 times since October 1987, certainly not a frequent occurrence. While there is no fault in imposing circuit breakers, it seems to be a limited remedy at best.

Runaway Giant?

The difficulties created by flash trading and high frequency traders are clearly of concern to the SEC. However, the inability of the SEC to confront the problem early and effectively has rendered them nearly incapable of properly combating the problems posed by these practices. Global markets have begun to rely on the abilities and effects that high frequency traders create within the markets. To seriously impede or totally eliminate their influence would fundamentally transform markets overnight. This is not to say that the SEC and other regulators cannot reign in the influence of these practices, but it would require a forceful approach and significant support from many market makers, two elements that do not seem likely to occur anytime soon.

However, even without this support, it seems feasible for the SEC to eliminate flash trading and the informational inequalities that it creates. High frequency traders could still survive, and even thrive, without the ability to access flash trading information. The large trade volume created by high frequency trading is not based solely on flash orders. These firms still trade extensively using normal access to information so the elimination of flash orders would not greatly upset equity markets. It seems foolish to allow a group that already possesses many unique advantages over the average investor the ability to expand that gap further. High frequency traders may find other ways to exploit their advantages if you take away flash trading, but at a minimum, the SEC should impose regulations that limit their advantages to information as well as speed. The SEC has dragged their feet for so long that the decision is now out of their hands in many regards. They still have the ability to regulate, but most regulation would merely create unnecessary volatility and uncertainty in an economy that is struggling to find stability. The questionable practices of flash trading and other methods employed by high frequency traders seemingly sprang up overnight, but it looks as if they are an evil we will have to live with unless the SEC starts following through on their intentions.   

Footnotes:

[1] Mark D. Perlow, Gordon F. Peery, & Robert H. Rosenblum, Perlow, Peery and Rosenblum on Regulators Focus on Flash Orders, Indicators of Interest, Dark Pools and Co-location, Matthew Bender & Company, Inc., 2010, at 1, available at LexisNexis 2009 Emerging Issues 4172.

[2] Id. at 2.

[3] Id. 

[4] Id. at 2 

[5] Id. at 3.

[6] Id. at 4.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

[11] Id. at 2.

 

Comments (1) -

1/5/2012 3:35:22 AM #

stockprofessor

That's really awesome.. I hope I can see more of this.. I am looking forward for your next post..

stockprofessor United States

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