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Tuesday, August 11, 2009

Flash Trading - To Be or Not to Be

Posted by Chris Martins

The goal of any financial market structure and its supporting rules should be to foster an environment of freedom and transparency where informed market participants can make trading decisions that reflect pursuit of their rational self-interest.  Now truly rational self-interest may be an ideal state that does not exist in the real world as it presumes a trading participant is fully informed and fully rational in their behavior.  Recent economic research (nicely covered in a recent Time Magazine article) suggests entities are rarely fully rational in their actions.  And in financial markets, the participating entities are rarely fully informed because conditions change too quickly and the meaning of the changes is often too opaque to achieve a fully informed state quickly enough.  So participants make educated appraisals with their trade decisions and iteratively appraise and reappraise those decisions as new data is received.

The goal of a regulator should be to try to ensure a reasonably level playing, with emphasis on "reasonable."  It is unrealistic to presume that markets can be perfectly level.  After all, the very term “liquidity” implies movement and fluidity that belies the notion that a perfectly level state can be achieved.  There must be some accommodation in regulatory actions to the natural dynamics of the markets and their participants, much like a sailor must accommodate the movement of the deck in even the calmest sea.  Without such accommodation, we will inevitably stifle the innovation and creativity that are the very foundation of the financial markets.  After all, a ship in dry dock is perfectly stable, but of little use to the sailor.

Regulators should also strive to balance the needs of individual trading entities with that of the trading population as a whole.  After all, one of the foundations of algorithmic trading is the use of technology to minimize order impact.  By mandating, per interpretation of Reg NMS, that orders not avail themselves of a “flash” are we not circumventing the interests of some traders (who wish to disguise their intent), by forcing their trade to be routed to open markets?  They might rationally choose the risk of possible front running vs. the risk of not finding liquidity or the transactions costs associated with that liquidity.  Routing to public markets offers no guarantee of best execution, since the Reg NMS best price standard does not necessarily account for factors like transaction cost or depth of liquidity in these “lit” markets.  Dark pools exist for a legitimate trading purpose.

As regulators look at flash trading and its impact, they should recognize that technology is a tool, neither benevolent nor malevolent.  Those that wield technology in the financial markets will do so in pursuit of their own interests.  That is a good thing because the advantages they seek are often transient and they prompt others to pursue similar advantages with similar vigor.  That vigor is the thriving pulse that has propelled capitalism and made the markets what they are.  The current markets are the better off because of the technology advancements that are currently implemented.  And those advancements were not the result of regulatory demands, but the rational pursuit of self-interest by market participants.   Regulatory restrictions are inherently a blunt tool, best wielded only after careful consideration.

Fair and open markets are a good thing, because they encourage participation in those markets.  Regulators should focus on that goal, because it achievable and because it is an area where the markets (exchanges, trading entities and regulators) all have a common goal.  But expectations must be tempered.  Fairness is not synonymous with perfect equality.  Regulators cannot mandate equal intelligence, equal technology or equal information among all participants.  Some will be better informed, more prescient in their views of the future, or just better equipped. 

As David Byrne might say [or sing], “same as it ever was, same as it ever was!” 

And that is not a bad thing.


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