Regulation of HFT

This week, I'm going to focus on the regulatory side of Wall Street. Especially in recent years since the Great Recession, there has been much debate about the extent to which the government should be involved in regulating the stock market. The U.S. Securities and Exchange Commission (SEC) is the entity responsible for handling this.

In July 2010, after much debate in the House and Senate, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed and put into law. This was in effect the first regulatory law on the stock market in decades, and brought about the most significant changes to the financial services industry since the regulatory reform that followed the Great Depression in the 1930s.

The aim of the act was:

"To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes."

Dodd-Frank consolidated regulatory agencies to streamline the regulatory process and increased oversight of specific institutions regarded as higher-risk. It also included consumer protection reforms to increase investor protection. Additionally, it provided tools for financial crises so that another crisis or "bail outs" won't happen again. However, as with all laws, it still has many opponents who either believe the law was not enough to prevent another crisis or that it went too far and unduly restricted financial institutions.

What about High Frequency Traders (HFTs)?

Countries in Europe like Germany and France have already implemented their own regulatory laws on HFTs. In Germany, a new law was passed this September that affects anyone trading in Germany, regardless of origin. The law requires traders to register first with Germany's Federal Financial Supervisory Authority, collects fees from those who use HFTs excessively, and forces markets to install "circuit breakers" that can interrupt trading if a problem is detected. Most importantly, the new law grants the regulator the power to make firms detail their trading practices. What to take from all of this: Germany isn't taking any risks, and no data is private anymore.

No laws of this sort has been passed in the U.S. yet. However, there is plenty of discussion and debate about it due to highly publicized incidents like the Flash Crash and Knight Capital crash, two events I covered earlier in this blog.

The SEC, highly criticized for not knowing enough about HFT to regulate it, is starting to play catch-up. They have started initiatives that will increase the amount of data received from trading exchanges and to record orders from their origination to execution. An office of analytics and research is planned.

A mechanism known as the consolidated audit trail will track all order and trading information as it is passed between brokers and private dark pools before they're compiled or canceled. Information like this has never been compiled before. The SEC also acquired a HFT firm, Tradeworx Inc., to help it develop it's data analytics system (dubbed "Midas", short for Market Information Data Analytics System). Midas will collect trading data that trading exchanges provide to the HFTs who want information milliseconds before the public.

Hopefully, all of this will glean some more information about how HFTs work and how they are able to affect the market. But there are always pundits who believe regulation by the SEC will only hurt the market. John Steele Gordon of Forbes says that "history shows that the financial industry doesn't need the government to help with reform."

In my opinion, gathering data can only help. The SEC is only trying to do it's job and prevent unfair trading practices as well as another crash. While we may be a few years removed from serious regulation of HFT in the U.S., this is a step in the right direction.

Sources:

[1] Christopher Lawton and Andreas Kissler, "Germany to Tap Brakes on High-Speed Trading", Wall Street Journal, September 26, 2012, http://online.wsj.com/article/SB10000872396390444813104578018292059338944.html

[2] Nina Mehta, "SEC Leads From Behind as High-Frequency Trading Shows Data Gap", Bloomberg, October 1, 2012, http://www.bloomberg.com/news/2012-10-01/sec-leads-from-behind-as-high-frequency-trading-shows-data-gap.html

[3] Nathaniel Popper and Ben Protess, "To Regulate Traders, S.E.C. turns to One of Them", New York Times, October 7, 2012, http://www.nytimes.com/2012/10/08/business/sec-regulators-turn-to-high-speed-trading-firm.html?pagewanted=all

[4] Roger Lowenstein (Op-Ed), "A Speed Limit for the Stock Market", New York Times, October 1, 2012, http://www.nytimes.com/2012/10/02/opinion/putting-the-brakes-on-high-frequency-trading.html

[5] John Steele Gordon (Op-Ed), "Wall Street Can Regulate Itself", Forbes, April 23, 2010, http://www.forbes.com/2010/04/23/wall-street-regulation-financial-reform-opinions-contributors-john-steele-gordon.html

[6] H.R. 4173 (Dodd-Frank Law), January 5, 2010, http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf

[7] Financial Crisis Interactive Timeline, http://www.dems.gov/financial-timeline

Spotlight: Knight Capital

Two weeks ago, I covered the Flash Crash of 2010. What was significant about the Flash Crash was the way the market had fallen so far in a span of only minutes, but we have to remember that the market recovered almost just as quickly. Individual firms and stocks only suffered net losses of a few percent at most. Additionally, the Flash Crash impacted lots of HFTs and so the losses were shared by the market as a whole.

What would happen in the possible scenario where some computer glitch could corrupt an individual trading firm's or hedge fund's HFT algorithm?

Fast forward to August of this year.

Knight Capital Group, a trading firm founded in 1995, had over the past few years grown to be one of the biggest "middle-men" in the market. Knight executes trade orders for retail brokers like TD Ameritrade and ETrade, and competes with the likes of UBS, Citibank and Citadel. It is headquartered in Jersey City, NJ, and had employed over 1,400 people in 21 locations around the world.

Up until this catastrophic event, according to Adam Sussman at the data company Tabb Group, Knight Capital was responsible for 11% of all trading in American stocks between January and May. This is no small fish!

On the morning of Wednesday, August 1st, crisis struck. Somehow, Knight's automated stock program flooded the market with trades. In the first 45 minutes that the market was open, a computer glitch in their algorithm caused the firm to buy and sell millions of shares of hundreds of stocks, causing the value of these stocks to soar upward. Knight blamed this on their new trading software, which was installed that same week.

Since Knight was now holding onto so many shares of these stocks, they had to rapidly sell everything to minimize losses. The problem was, however, that their shares were overvalued because of their glitch. They had to sell their losing positions back to the market and take losses, which totalled $461.1 million.

According to the New York Times, that's $10 million lost per minute. Wow.

These total losses were greater than the revenue that Knight Capital earned in the second quarter of this year, which was $289 million. Because of this disaster, Knight had to seek help from a group of customers and rivals. The Wall Street Journal reported that it's share price was down 78% as of mid-October.

Thankfully, the rest of the market wasn't impacted. This could be due to volatility controls put in place by the SEC in the aftermath of the Flash Crash.

Some questions linger after the incident. Why didn't traders from Knight Capital step in and stop the rogue algorithm? Are the current safety regulations set in place by the SEC enough to stop glitches like this from happening again?

In my opinion, I think there's a very low chance of something like the Knight Capital incident happening again. The Flash Crash happened once, and now regulators have learned to put safety nets in place to save the market in such a scenario. We learn from our mistakes, so every other firm in the market will be sure to check for bugs in their algorithms once more because they don't want to be the next Knight Capital, losing millions of dollars.

Sources:

[1] Jacob Bunge, "Knight Plans for Worst and Hopes for Best", Wall Street Journal, October 17, 2012, http://online.wsj.com/article/SB10000872396390444734804578062174162145686.html

[2] Danielle Douglass, "Computer Glitch Sent Markets into a Tizzy", Washington Post, August 1, 2012, http://www.washingtonpost.com/business/economy/computer-glitch-sent-markets-into-a-tizzy/2012/08/01/gJQAwNsMQX_story.html

[3] "How Safe Is Computer Trading After Knight Capital Crash?", The Week UK, August 3, 2012, http://www.theweek.co.uk/us-business/48304/how-safe-computer-trading-after-knight-capital-crash#

[4] Nathaniel Popper, "Knight Capital Says Trading Glitch Cost It $440 Million", New York Times, August 2, 2012, http://dealbook.nytimes.com/2012/08/02/knight-capital-says-trading-mishap-cost-it-440-million/

Financial Stability of HFT

Over the past two weeks, I've highlighted the impact of High Frequency Trading (HFT) on the stock market, including the 2010 Flash Crash example. Obviously, today HFT makes up a big part of the trading that goes on at Wall Street. In this post, I'd like to consider another ongoing issue involving HFT - what is it's impact on market volatility? Does HFT make the market more stable, less stable, or actually have no effect on volatility?

Last week, I introduced the subject of volatility as the variation of price over time. This is true, both in a specific sense of individual stocks and more generally as you look at the whole market. In a more volatile market, prices fluctuate more frequently and with more magnitude - there's more movement. Lately, especially within the past year, market executives have described the market as more volatile than ever. Their evidence are indices like the S&P volatility index (mentioned last week) that seek to measure the overall market's stability. Can we attribute this increased volatility to HFT?

This is the question that has yet to be answered in a unified way. According to an article by Forbes Magazine, HFT doesn't cause volatility in the market but amplifies it.

"High Frequency Trading feeds on volatility because the computers aim to make a profit on the spread - the difference between the buy price and sell price of the stock."

When this spread widens, the computers then go into overdrive, making more and more trades to generate profits. This, according to Forbes, creates a "snowball" effect, amplifying the market move up or down.

Similarly, another source, the Government Office for Science in the UK, points to self-reinforcing feedback loops that amplify the volatility in the market. Their paper, "The Future of Computer Trading in Financial Markets", identifies three main mechanisms by which may lead to instability in markets: nonlinear sensitivities to change (when a small event can have a big impact on the market), incomplete information (where some firms can have more information than others), and internal "endogenous" risks based on feedback loops within the HFT system. The article names six different types of feedback loops that can contribute to this endogenous risk. While these feedback loops in the HFTs may be well-intentioned, they can amplify internal risks and lead to undesired outcomes when a small change loops back on itself and triggers a bigger change which again loops and so on.

The Government Office for Science paper asserts that there is no direct evidence that HFT has increased stock volatility. Yet, using data from a large sample of firms from 1985 to 2009, Frank Zhang from Yale found that HFT increases stock price volatility. The positive correlation that he found was especially strong for the top 3,000 stocks in the market. However, does correlation prove causation? Not necessarily.

Additionally, we have to remember that there have been volatile events in the market before HFT came along. According to Forbes, the level of volatility in the Great Depression starting in 1929 was only 0.3% lower than that of the Great Recession of 2008-2009.

Perhaps the best explanation we can give is that HFT and volatility are intermingled. This is position of Jonathan Brogaard of Northwestern, who published a paper in September of last year about the subject.  Using mostly data from the financial crisis separated into two swathes (HFT activity and non-HFT activity), he ran a statistical method called a Granger Causality Analysis to investigate the relationship between volatility and HFT activity. He found that the relationship goes both ways - volatility can cause HFT activity and HFT activity can cause volatility.

It goes without saying that the relationship between market volatility and HFT is a complex one. With hundreds of thousands of trades per day, all controlled by computer algorithms, it's hard for anyone to find a precise explanation for it. However, we do know that they are related in some form - and that's a start.

Sources:

[1] "Are Computers Bringing Down The Stock Market?", Forbes Magazine, August 15, 2011, http://www.forbes.com/sites/investopedia/2011/08/15/are-computers-bringing-down-the-stock-market/2/

[2] Jonathan Brogaard, "High Frequency Trading and Volatility", Northwestern University Kellogg School of Management, September 8, 2011, http://www.wsuc3m.com/HFT_and_Volatility_Final%20Brogaard.pdf

[3] "The Future of Computer Trading in Financial Markets", UK Government Office for Science, 2011, http://www.bis.gov.uk/assets/foresight/docs/computer-trading/11-1276-the-future-of-computer-trading-in-financial-markets

[4] Frank Zhang, "High-Frequency Trading, Stock Volatility, and Price Discovery", Yale School of Management, December 2010, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1691679