Posted by John Bates
"For a charm of powerful trouble,
Like a hell-broth boil and babble
Double, double, toil and trouble,
Fire burn, and caldron bubble."
There is no shortage of news about the evils of high frequency trading these days; almost as if the whole thing is turning into a witch hunt. According to Wikipedia: "A witch-hunt is a search for witches or evidence of witchcraft, often involving moral panic, mass hysteria and lynching". I don't think we will get so far as lynching, but a certain amount of hysteria and moral panic are certainly present in the marketplace.
NY Senator Charles Schumer is keeping HFT in the headlines, recently claiming the players pulled out during the flash crash "leaving a dearth of liquidity and exacerbating market volatility." Last week SEC Chairman Mary Schapiro told the Security Traders Association (http://tinyurl.com/37rmo68) that she was concerned about not just HFT but also whether high frequency players should be regulated in "key aspects of their market behavior, including quoting and trading strategies.”
She also expressed concern over execution algorithms: “Even with checks for ‘fat finger’ errors and other problems, these algorithms can quickly generate a volume of orders that swamps the immediately-available supply of liquidity for a stock.”
And most recently, the Investment Company Institute, a trade association for fund managers, is said to be meeting in Washington, D.C. to push for a plan to restrict high-frequency trading. Some ICI leaders contend that HFT profits may come partly at the expense of ordinary investors (http://tinyurl.com/35b2xnl).
I'd like to turn the fire down under the witch's cauldron and avoid a witch hunt. Like witches, HFT is not evil - just misunderstood. Witches of lore used the tools at their disposal, whether eye of newt or toe of frog, to get the job done. There was never much evidence that the job in question was evil-doing, but they were persecuted nevertheless. The same can be said of HFT and algorithmic trading. They are just some of the trader's tools that help to get the job done efficiently, and are also misunderstood.
Algorithmic trading and HFT are less like witchcraft and more like gold mining. When gold is discovered a rush ensues and everyone descends upon the territory. Then they have to pan for gold in rivers or dig to find the hidden seams of gold. Using algo and HFT trading firms are always seeking out new opportunities and trying to mine the gold before others descend.
I'm not saying that there are no issues with HFT. It can scale the capabilities of a trader hundreds or thousands of times - which can of course increase trading risk accordingly. But rather than burn the witch, or HFT, we need to find ways to control the risk.
High frequency pre-trade risk capabilities will help. Using a real-time pre-trade risk firewall it is possible to continuously recalculate risk exposures while monitoring trades as they go to market - and determine what impact they would have on pre-defined risk limits.
Using back-testing and market simulation is another; before algos go live it is possible to see how they would perform in production. Real-time market monitoring and surveillance allows more rapid response to potential crises and market abuse – potentially allowing rapid action to prevent or minimize any market impact. Finally, keeping an audit trail of market data and potential abuse cases is also important. Tick databases can be used here.
The thing to remember is that HFT and algo traders are not evil witches. There are many positive aspects of algorithms and HFT. They minimize market impact of large trades, lower the cost of execution, make more open and efficient markets, allow trading venues to evolve faster, encourage entrepreneurship and increase trader productivity, among many other things. Rather than organize an HFT witch hunt and run around shouting and carrying torches it would be much more productive to look at how HFT can benefit from effective controls. We must be careful not to over-regulate and damage this important economic engine.