High Frequency Trading Destroys Market Integrity
It is pretty clear to most everyone that high frequency trading (HFT) destroys market integrity. In recent comments on my blog post, Strongly Regulate High Frequency Trading, Colin Clark shift’s the discussion away from HFT and points the finger at other market fundamentals. I agree with Colin that there are certainly myriad other problems caused by greedy financial services firms, but those issues are a different discussion, mostly orthogonal to the HFT issue.
John Bates comments in reply to my post are on track, where he says:
“The point I was trying to make is that you can protect investors from some of the rapid movements that HFT can accentuate by having electronic safeguards — like real-time pre-trade risk and real-time market surveillance.”
In order to address this objectively, we need to look at this problem from an information security perspective. In Infosec, there are three types of security controls:
- Logical controls,
- Physical controls,
- Administrative controls.
John is advocating the application of logical controls (software technology) and cautioning against the use of administrative controls (government regulations). This is the natural position of most technologists, by the way, and most CTOs would not be CTOs if they positioned otherwise. Their job is to advocate technological solutions, which John did. There is an old saying, “Where you stand is based on where you sit”. It is professionally correct to take positions based on where you sit (your position). You can see John’s considerate reply here.
An excellent 2009 article in the New York Times, Stock Traders Find Speed Pays, in Milliseconds, is quite revealing on the problems with HFT. Below are a few direct quotes from that article:
“… high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. – NY Times“
“If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage. -NY Times”
“While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee. – NY Times”
“… we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity. – NY Times”
Basically, the markets has already lost much of their integrity because of these “loopholes” that the NY Times has pointed out. That is one of the major reasons we see these wild instabilities in the market place that have little do with market fundamentals. I agree that market fundamentals are certainly influential, as Colin has reminded us, however, the “unfairness” to “normal investors” created by HFT is a discussion that is mostly unrelated to other problems we are seeing. HFT is a serious problem that undermines market integrity.
I agree with John Bates that logical controls are important. However, administrative controls are also very important, and generally more important. There should be a regulatory framework that insures that technology cannot be used to put individual investors at a disadvantage. Regulatory loopholes must be closed. When a regulatory framework is in place that does not create unfair advantages to traders based on technology (i.e. who has the fastest gun wins the gunfight), it is certainly possible to use logical controls to help insure that these rules are followed, as John has pointed out.
The reason I responded directly to John Bate’s original post on this topic was not to single out John or Apama. John is doing exactly what a CTO should do – advocating technology to solve problems. All technology CTOs who are doing their jobs correctly must do this. However, since I am not in the shoes of a CTO who has a job selling technology (logical controls), I think it is necessary to point out that administrative controls (regulations, laws, policies and other rules and guidelines) serve as the critical backbone of all security plans. Having said that, if I was CTO I would also be pointing out the importance of administrative controls as well. Perhaps that is why I am not a CTO!
As a side note: I recall before leaving TIBCO Software, my boss told me that “software companies” have no place for independent consultants.
There is no doubt that the loopholes in the stock market regulatory framework creates a multi-tiered system that provides a distinct advantage to firms who invest in the technologies required to win the trading “arms race” game. This undermines the integrity of the “investor’s market”. The NY Times predicts that “markets will loss their integrity”. Many of us believe that has already happened.
In closing, John is correct to point out that logical controls are an important part of the solution. It is also just as important to point out the administrative controls are important. In fact, if you look at most information security (and integrity is a part of information security) solutions, administrative controls are often more important than logical controls and they certainly form the framework by which to build the required logical controls.