Financial Innovation and Market Structure

By

Irene Aldridge; Haim Bodek; James H. Freis, Jr., CFA; Gemma Godfrey;

High-frequency trading (HFT) is a topic we come across a great deal these days. Since the publication of Michael Lewis’s Flash Boys in March 2014, HFT has been a hot-button issue worldwide. In the book, Lewis skewers Wall Street by claiming firms use technology to rig the markets. However, like so many things in life, the issue is complicated and probably not as straightforward as Lewis claims.

With that in mind, it is worth exploring exactly what HFT is and what it means for markets. To help answer these questions, a blue-ribbon panel was assembled at the 68th CFA Institute Annual Conference in Frankfurt, Germany, to discuss the issue. The panel consisted of Haim Bodek, who gained notoriety as a whistleblower on rigged order execution; James H. Freis, Jr., CFA, the former director of the US Treasury Department’s Financial Crimes Enforcement Network (FinCEN); Gemma Godfrey, the head of investment strategy at Brooks Macdonald; and Irene Aldridge, an expert on algorithmic trading.

Perhaps the most important takeaway from the program is that HFT is not a strategy in and of itself — it is a technology that can be used for good or ill. Just like Bernie Madoff ripped people off, some unscrupulous investors and traders are using HFT to take advantage of people. Is this really new? So while the outrage that accompanied Flash Boys has merit, it just appears to be misplaced. Some HFT funds do, in fact, provide market liquidity, which is a valuable service for institutional investors seeking liquidity in otherwise illiquid positions. However, others exploit market structure and create unnecessary costs and risks for others by cutting to the front of the line. So, it is not at all as clear-cut as Lewis might have you believe. Moreover, even the ones acting unethically are not necessarily doing anything illegal. As Bodek said, “the existing regulatory structure is inadequate because many of the questionable practices are not illegal.” So, regulators are behind the curve once again as many HFT firms arbitrage the existing rules.

At the forefront of change is Germany, which in 2013 implemented a HFT law that requires licensing of HFT firms and puts limits on order-to-trade ratios (i.e., limiting orders where there is no intention to trade, such as “wash trades, layering ,and spoofing”). According to Freis, the law in Germany has been effective and has prompted other countries to take a closer look at their framework.

Meanwhile, reports of HFT excesses continue to roll in. In one recent case Societe Generale’s brokerage unit, Newedge, was fined $9.5 million by FINRA for manipulating markets with HFT. In another case, Navinder Singh Sarao, a single trader working from home, allegedly caused the Flash Crash of the S&P 500 in 2010 and was arrested by authorities in London. But determining the authenticity of these claims is much trickier than it might sound. For instance, the lone wolf in London story has some hurdles to overcome in making the case that a single trader brought down the deepest and most liquid equity market in the world.

In other cases, brokers are using HFT ethically to get rebates from exchanges by providing liquidity, but then keeping the liquidity rebates for themselves, rather than passing the savings along to investors. So, their use of HFT is clean, but the broker’s behavior within the traditional brokerage operation is problematic. So, no matter how you slice it, the problem seems to come down to bad actors, not the chosen tool.

To be sure, the panelists had different views to share on the topic of HFT, but they all agreed on one thing: HFT is a natural step in the evolution of markets. Ethical breaches associated with HFT are what the world needs to focus on. Eventually, regulators will catch up. In the meantime, investors must press for transparency and fair dealing with brokers and the HFT algorithms that they employ.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: W. Scott Mitchell

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