CFTC Cracks Down on High Frequency Traders

Jeff  Carter
Posted: Mar 17, 2012 12:01 AM

The FIA convention is taking place in Florida and sometimes big news is released there. Yesterday, the CFTC said it was going to monitor high frequency traders (HFT) a lot more closely.

Regulators are ramping up oversight of high-frequency trading, which some fear could disrupt or distort financial markets with aggressive, rapid-fire trading strategies. Some more traditional institutional trading firms worry that uncompleted orders are sometimes used to manipulate markets by making it appear there is more interest in buying or selling a contract than there is in reality.

Better late than never. They have been so pre-occupied with sinking their fangs into the spoils left to them by Dodd-Frank that they forgot they needed to regulate a marketplace. Hey, CFTC, last October there was this bankruptcy that rocked the futures world. Had something to do with MF Global. Maybe it’s time you get cracking on that. Customers were defrauded and executives still roam the streets freely. Gary Gensler has been one of the worst chairs the futures world has seen.

The market place has definitely changed since the advent of computerized algorithms began trading. Long term traders anecdotally say the volatility has changed. Moment to moment or, “marginal volatility” is a lot different. In statistics, you might say the bell curve around any particular mean price has greater variance. They also say that the bid/ask spread is a lot thinner than it used to be. It used to be that if you got nailed with a bad trade, you could get out or could count on a place to spread the trade off. No more.

One long time futures trader remarked to me once, “When we didn’t have computerized trading I was right 70% of the time, and wrong 30%. I always bought the high and sold the low of the day. But it was never fatal. Now, no matter what trading strategy I employ, no matter how I time my entry, I am always 100% wrong.” He is not alone in his sentiment and I think the CFTC ought to listen to the long time traders, and not exchanges or brokerage house executives.

I don’t think that over the long haul any HFT trader, or even a cabal of HFT traders, can influence the settlement price of a commodity. Actual on the ground supply and demand does that. But, moment by moment they do cause distortions in the marketplace. No doubt all the nefarious practices that have been uncovered in the SEC regulated marketplaces carry over to the CFTC regulated ones. However, because the playing field is far different, the economic and functional effects of those practices have different outcomes.

One thing that sticks in my craw that is inside baseball. If you never traded on a floor, you might not understand it. The exchanges allow HFT traders to co-locate. This gives the HFT algos a time advantage over the rest of the marketplace. They can exploit that time advantage to the tune of billions of dollars in profit each year. Many HFT houses have programs that can statistically analyze the book and order flow and because they have the time advantage they take advantage of it. Bear in mind, it’s not illegal to create a program to statistically try and figure out the book, but because of the unfair time advantage, a tiered playing field is the result. That tiered playing field leads to a lot of the marketplace being treated like second class or even third class citizens.

The reason that anyone owned an exchange membership was because it not only gave you lower fees, but it gave you proximity to order flow. The exchanges have devalued equity memberships by giving HFT firms proximity to order flow and remitting nothing to their equity members. It’s a negative externality that persists in the market, and the equity owners at exchanges haven’t been compensated for that externality.

It’s not possible, nor am I advocating for, an end to electronic trading in the marketplace. However, only one electronic way has been engineered. Despite all the lip service paid to not being afraid of competition in the marketplace, banks and exchanges spend an awful lot of time creating artificial legislative/regulatory barriers to protect themselves. If the barriers to entry to forming a regulated exchange were lower, perhaps someone would dream up a different way. It costs millions to start up an exchange today. Out of the box thinking entrepreneurs could revolutionize the marketplace to be better, flatter and even more transparent place to do business. No doubt, someday there could be an app for that.

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