The HFT challenge to global equity markets

24th September 2012

Two excellent recent commentaries on the High Frequency Trading (HFT) dilemma have shed new light on the problem that is perplexing securities regulators around the world. The fear is that ever faster algorithms and more powerful computers not only will distort, but are already distorting global equity markets. Larry Tabb, found and CEO of the market analysis house, TABB Group, has written an illuminating piece on how markets are being fragmented across multiple dimensions , while Pragma Systems, an electronic trading boutique specialising in algorithms, has produced a paper arguing that a good chunk of HFT profits are paid for by ordinary investors.

Tabb's article, entitled: "Fragmentation is redlining the markets", sees three dimensions along which markets can fragment. The first and most obvious is the proliferation of trading venues. When a seller wants to sell a security, whatever trading platform they are using will be programmed to check all possible trading venues available to it in order to find the best price to match the trade against. Tabb points out that the US alone has 13 recognized trading venues and 50 "dark pools" (institutional trading volumes that are unavailable to the public). Adding to the number of trading venues adds to the compute task for price matching.

Time and price are two other dimensions on which markets can fragment. Price fragmentation comes as trades speed up and quotes start adding decimals to the price. Similarly if the quoting frequency changes, as Tabb points out, "from seconds, to tenths, to tens of milliseconds, and then down to milliseconds," the quoting rate climbs proportionately. The more quotes that have to be checked the more the market fragments, tying up programming time simply trying to scan all possible quotes to find the best price at which to do a trade. If you multiply the fragmentation across multiple venues, multiple price points, and multiple fractions of a second, and then multiply again across 5,000 stocks, you have a massive technology and message infrastructure that you require simply in order to trade at "best practice", ie matching potential buyers and sellers at the best price.  As Tabb notes, what all this means is that the quote-to-trade ratios have gone through the roof, with vast numbers of quotes having to be scanned to produce a single trade.

Given the problems with the Flash Crash, Facebook and now Knight, has our market become too fragile? Has the technology surpassed our management capabilities? Have the regulators been left in the dust and investors on the sidelines? Increasingly, I believe that, yes, our fragmented infrastructure needs to be simplified. No matter how technology proficient the firm, these systemic problems hurt investor confidence and trust.”

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