April 10, 2014

A new book about high frequency trading -- written by business storyteller extraordinaire Michael Lewis -- has thrown the media into an inexplicable tizzy. Lewis' book takes some potshots at HFT, saying the stock market is "rigged" by Wall Street insiders and exchanges.

The furor, following the release of "Flash Boys," which is currently #1 on Amazon's best seller list, was surprising, given that anyone involved in trading, technology, regulation or business journalism has been aware of HFT for years.

Regardless, business and even the mainstream press are bellowing to the skies about the unfair advantages HFT firms have, with their fiber optic lines and their servers collocated onsite at exchanges. They are rending their garments to show how upset they are about "insider trading 2.0", or HFT practices that many think ought to be illegal.

They are beating their chests about the cost to little-guy investors, who are unlucky enough not to have an ultra-high speed trading platform at their fingertips.

The outpouring of emotion is puzzling, as none of this is news. Regulators have been trying to get to grips with HFT; even before the May 2010 "Flash Crash," when an algorithm sent the market spinning out of control and caused the biggest one-day point decline in the DJIA.

In June 2010, I wrote in Wall Street & Technology that regulators had fallen behind in scrutinizing the markets that they are responsible for because they lacked the money to buy the high speed tools they needed to get the job done.

Regulators Playing Catch Up

The Securities and Exchange Commission has not been ignoring HFT, on the contrary. It is at the mercy of annual budgets set by painful negotiations with Congress and is thus at a disadvantage to Wall Street banks and hedge funds with oodles of cash. The UK's Financial Services Authority likened the struggle to "chasing a Ferrari whilst riding a bicycle."

In May, 2012 I blogged that HFTs were being compared to everything from rats in a granary to highway robbers intent on stealing Granny's pension.

Today, as it was two years ago, bashing high frequency trading firms has become the latest sport in the financial services industry.

Again, as in 2010 and in 2012, there are calls to ban it. I think this would be unwise and unnecessary.

HFT is actually just normal-but-very-quick-trading, which profits from very short-term pricing anomalies between two or more products or liquidity sources. This is called arbitrage and is a common trading practice. With HFT, arbitrage is simply done at very high speeds. However, when HFT becomes a dominant force in the market (and books like "Flash Boys" come along), non-HFT investors may want to stay away. This is worrisome to all market participants, as liquidity would suffer. I have suggested that what is needed is not a ban on HFT, but a mandate for high frequency surveillance, preferably in as near real-time as possible. That way humans can respond to manipulative behaviors as they are happening, rather than in minutes or hours or days (or never). Proactive use of real-time monitoring systems can alert regulators to problems before they become a crisis. Such systems can tell regulators how much market manipulation is going on -- such as traders trying to drive price up and down by fiddling with the market, or painting the tape.

Monitoring technology can 'see' major price and volume spikes in particular instruments, how often they happen and maybe even why, and whether a pattern in market behavior caused them. And they can flag liquidity concerns by monitoring how liquidity moves across venues. They can tell how much potential trader collusion is going, such as wash trading. They can spot potential insider trading by correlating unusual trading incidents with news releases and market movements.

From lighting up the dark pools, where a lot of the trading is being done, to identifying patterns and anomalies in transaction data and dealer behavior, market surveillance can be the real-time watchdog. This avoids the need for draconian HFT regulations or banning the practice altogether.

Dr. John Bates is a Member of the Group Executive Board and Chief Technology Officer at Software AG, responsible for Intelligent Business Operations and Big Data strategies. Until July 2013, John ...