Photo: Associated Press
There is a lot of talk about what the results of the SEC’s probe into what caused the May 6 Flash Crash, which are due later this month, will turn up.The investigation, which centres on high frequency trading, and in particular, the criticisms of high speed trading like that it manipulates the market, might ultimately result in reforms if high frequency trading is determined to be a problematic and solvable cause of the May 6 Flash Crash.
The report is expected to touch on these issues:
- Whether issues related to high-volume cancellations were one of the causes of the flash crash
- Whether the firms that effectively act as market makers during normal times should have any obligation to support the market in reasonable ways in tough times
- Whether orders placed in one-tenth of a cent should be allowed
HFT rivals, day traders in particular, want all of these issues addressed with new reforms.
The SEC says it got over 200 comments from people about what’s wrong with HFT. We’re guessing many of the comments came from their rivals.
- “Quote-stuffing,” or flooding the market with quotes on which high frequency traders never intend to trade (The theory is that they’re drawing out the best offer and making it appear like there’s much more trading volume in a stock than there actually is. They trash the market with quotes then just cancel them a split second later.)
- Sub-penny pricing (When the orders are priced just sub-pennies away the actual price at which a stock is trading. Done in bulk, the practice could drive a stock’s price down.)
- Whether or not the quality of price discovery has declined
- Whether or not changes in our market structure prompted by new technology undermines the fair and level playing field.
But it’s hard, if not impossible, to prove that HFT traders have behave illegally. First, because the SEC readily admits they don’t know who many of the HFT traders are.
And second, because of course there would be more cancelled orders in a higher speed market with much higher volume (and about 60% of it coming from HFT). By nature, traders constantly provide quotes for potential trades and then cancel them – they’re looking for the most profittable trade; it’s basic market-making.
It’s also hard to require firms to be market-makers, simply because firms will not provide a market for a trade that doesn’t benefit them. Market-making requires time and money, so there has to be something in it for them.
So, not surprisingly, in Mary Shapiro’s recent speech announcing the reforms the SEC might make in HFT, Shapiro hints that the changes won’t focus on requiring HFT firms to be market-makers or restricting volume by restricting how large orders are placed. They would be too drastic and unfounded.
It seems like instead, Shapiro is focusing not on wrongdoing by the HFT industry but on the lack of confidence in the markets because of suspicions about the Flash Crash (and suspicions about the role of HFT in causing it).
She notes a few times in a talk before The Economic Club of New York that reform is needed to restore confidence in the market, because “individual investors — have pulled back from participating in the equity markets since May 6.”
“Indeed, according to mutual fund data, every single week since May 6 has seen an outflow of funds from equity mutual funds.”
So, judging by her comments, the SEC’s conclusion in the upcoming report will probably be that at least some new restriction on HFT is needed to return confidence to the market.
And we’re guessing that the report will suggest that the decision made in 2000 to price quotes in decimals is changed – and puts a restriction on quotes that are priced in too-small increments for their stock price. Mostly, we think that because Shapiro said this:
“Our next steps are likely to include a careful review of a limit-up/limit-down procedure that would directly prevent trades outside specified parameters, while allowing trading to continue within those parameters.”
So here’s our prediction: It sounds like what Shapiro is saying is that the outer limits will be determined based on a stock’s price. Like a stock worth $2 could be priced in more decimals than a stock worth $100.
We’d be surprised if the SEC announced more than one change at a time, but if they do, here are other (unlikely) possibilities:
- The SEC could require quotes “stay” for at least a second (or some time) before they are cancelled
- The SEC could require some high volume HFT firms to act as market makers
- The SEC could announce some condition for exceeding some max number of cancelled trades
But we think those are unlikely for reasons mentioned above, and that the main change will be our bolded prediction above.
How will that change the war between high frequency traders and day traders? It will help a bit because it addresses one of their main complaint against the HFT traders, that they jump in front of their quotes and change the price by a tiny fraction.
But the war will continue.
For more on this topic:
Read more on the changes in Investment News >
Read more on quote-stuffing in the Wall Street Journal >
Read more on the exodus of retail investors/lack of confidence on the AP >
Read the CFTC commissioner’s, Bart Chilton’s, comment on why HFT is bad for the market >