Markets technology and laws respond to high frequency trading

Changes as markets technology and laws respond to high frequency trading

For years HFT influenced stock markets to change giving them very profitable advantages. As a result, they succeeded in keeping managements of most exchanges and regulators on side with rich revenue streams. To be sure, offers of a fat fee stream could be very persuasive. In any event, it seems to have done ​the trick! Exchanges stoutly defended HFT.

However, change, the market’s constant companion, may now make a difference. Market technology and legal responses could bring changes. If so, that could shift markets to remove some or all the tilt that favors HFT.

As a result, changes that could be on the way for investors include:

First purpose built exchange begins influencing markets

The new IEX Exchange leads the movement to change markets to offset HFT. Their project builds on a series of innovations. To begin there is an innovative technology speed bump, they could tilt markets. In that case, the IEX tilt would be to level the field. So, the following section of this lesson gives their innovations further coverage.

Other Exchanges also begin to propose changes 

When IEX began operations pressure increased on other exchanges to respond. Several copycat versions of the speed bump appeared. However, other innovations and technology are under consideration as well.

Legal responses to high frequency trading

Court challenges have begun with suits in several nations. It is possible that legal actions may complicate on-going market and trading operations. Also they may complicate any regulation of HFT.

Tax possibilities proposed by several jurisdictions

Politicians in multiple markets saw taxing HFT as a way to fight for the “common man”. It returns again and again as a tax the rich idea but shows little traction.

Even the SEC may finally respond with regulation

Showing signs of life, the SEC eventually showed up. As always, underfunded and outgunned regulators are well behind market developments around HFT. Most likely an SEC response with be to continue to “study” the issue and talk of regulation but produce little real action.

IEX Exchange leads the change as markets technology and laws respond

The biggest reply to the HFT stock exchange fixes has been the IEX Group. Considering, Markets technology and laws respond, the IEX is the premium reaction to HFT. It happened when the IEX Group founders had a brilliant insight. Given their insight, they saw a way forward and a way to overcome the HFT market rigging. As a result of realizing that only a market force response could affect any real needed change, they set about doing just that.

Their creation was the IEX Exchange to combat the effects of HFT. They wanted to apply market forces to the HFT marketplace. Doing that would overcome the market enabled rigging.

We first met the IEX Group in Lesson 5. At that time we learned that they were at the heart of the story outlining how the media exposed HFT to the general public.

7 IEX innovations change markets

Listed below are the core 7 IEX innovations that level markets for investors:

Speed bump technology - First innovation

At the core of the IEX plan is a technology speed bump. The IEX speed bump aims to combat predatory HFT. In order to do that, the speed bump adds 350 microseconds to all orders. Even that tiny time addition lets the matching engine process NBBO before any sales.

You will recall NBBO, we discussed in Lesson 8. In that lesson we covered the SEC required national best bid and offer price that must be available to everyone. As well, and also from earlier lessons, we know a matching engine is the computer heart of each stock exchange.

With the matching of orders gets made before HFT can react, the speed bump removes their ability to be first to trade. As a result, the HFT price advantage is gone. Taking away their best price advantage happens by slowing HFT down by that tiny 350 microseconds. As a result, IEX nips or removes the HFT speed advantage on their exc hange.

IEX has other plans and policies to level the playing field and remove the tilt of markets favoring HFT. For example, their technology speed bump is first and leading innovation. Second is their decision to offer no colocation service. One outcome of not letting HFT colocate keeps their trading a level field. That means IEX does not let HFT servers locate in their exchange next to the matching engine.

Colocation services not offered - Second innovation

Keeping IEX colocation free eliminates the potentially profitable revenue from selling that inside service. By doing that, IEX ​became the first exchange proposing and actually not sell out investors for a huge stream of HFT colocation fees.

In contrast, other exchanges took those colocation fees and sold out investors to give HFT an inside track to markets. By doing that, and selling HFT server locations close to their exchange matching engines, HFT consistently sees data before investors. By not providing those services, IEX removes another HFT advantage that tilts to rig markets.

Special data access not offered - Third innovation

IEX provides no special access to data. HFT pays exchanges many millions for premium data feeds. Those feeds let them see investor orders from brokers and exchanges. That has the effect of giving them advanced looks at your and all other investor orders. Doing so lets them trade against those orders for guaranteed profits time after time. In contrast, IEX provides no special data access.

Liquidity rebates not offered - Forth innovation

IEX offers no rebates to liquidity providers. As a result and by charging the same flat trading fee to all buyers or sellers, the trading floor gets leveled. Imagine, the IEX Group comes up with the innovation of a level trading floor and a fair price!

Custom HFT orders banned - Fifth innovation

IEX innovation of restricting orders to stop all custom HFT orders. This innovation counters order types created for HFT. Those unique order types get used to manipulate markets to the advantage of HFT. Eliminating HFT custom orders makes them focus on four basic orders types. Those order types are: market, limit, midpoint peg and fill or kill which has been branded as the IEX Check.

Exchanges respond as well when markets technology and laws respond to high frequency trading

Beyond IEX, some established exchanges also react as markets, technology and laws respond to HFT investor abuse. Following the need to battle for years on a long road to open the IEX, the day finally came. And as expected the evolution of IEX means markets have changed. As a result, markets or more correctly, exchanges, are now forced into the process of responding to their innovative changes.

One by one other exchanges have realized the need to get in front of changes that are clearly on the way. So see the following sections for some of these changes. Eventually, and although almost incredible, the innovative technology speed bump is now on its way to becoming an exchange standard!

ICE turns on a second light of hope

If IEX was the first exchange to turn a light on in the dark HFT tunnel, the Intercontinental Exchange (ICE) was next. And once ICE turned on a second light in early in 2019, it seems the use of technology speed bumps will grow.

While IEX gets unfairly called small time. ICE are certainly big time players. ICE owns 12 financial and commodity markets including the big daddy, NYSE. Beginning in Feb. 2019 they propose to scrub the HFT advantage in their gold and silver futures market.

This huge change is the first crack in the wall of exchange resistance! After IEX this is the second exchange to propose taking away the HFT speed advantage. In this case the speed bump will stop some gold and silver manipulation.

Like IEX, ICE proposes to scrub the HFT speed advantage with a technology speed bump. Perhaps this is the beginning of a trend as exchanges step back from the edge of the abyss!

ICE proposes to build in a 3 millisecond delays to scrub the HFT advantage. One result of this innovation, named Passive Order Protection or POP, it could be a sign of more technology innovations to come for all markets!

Aquis Exchange slams a European door as markets, technology and laws respond to high frequency trading

Then a third light goes on! Aquis Exchange is a pan-European independent exchange that banned HFT in 2019! The market responded by doubling their market share in 5 months! That is a market force response!

The change stopped parasitic HFT frontrunning cloaked as market making. Finally these guys have it right! They call out the HFT market making for what it is, parasite trading praying on investors.

HFT is not market making but a shakedown taking cuts off investor orders at zero risk. These schemes are effectively, if not legally, front running. You may recall, in Lesson 6 we covered those explanations in detail.

As alternatives become available to investors, front running HFT strategies may become ineffective. They could get turned on themselves. Investors and fund managers can avoid venues and trades that give HFT advantages. That could become the market force that did. It could stop HFT manipulation in rigged markets. That could change markets and investing for the better.

Speed bumps promise increased fairness

Imitators continue to pick up the IEX speed bump idea. Several more exchanges announce or acknowledge considering the use of speed bump technology. This could take time but could mark the beginning of the end of investor abuse by HFT. That will certainly be evidence of technology put to good use. Markets, technology and laws respond to hit HFT in the bottom line. That can bring change to markets.

Exchange circuit breakers, kill switches and trading halts

A series of crashes and spikes forced exchanges to act. Most developed a circuit breaker or trading curb strategy. Such strategies combine management and technology halting trading when markets move too quickly.

Preventing market crashes or extreme spikes is the reason for these dampening efforts. Once established, these market stabilizing tools should prevent market crashes. Market spikes, plunges and disruption get tied to HFT.

As noted in Lesson 10, HFT can disrupt markets, investors and undermine confidence. To counter some of those effects, circuit breakers can contain disruption. That happens when circuit breakers or kill switches stop trading during a disruption. As a result, a kill switch can instantly stop trading. D oing that prevents an exchange event from cascading across Globally interconnected markets.

By both stopping trading and cancelling open orders, kill switches stop and clear the exchange processors. At the same time, they also impose a trading halt on that exchange. When needed on a particular market, the simple bit of technology has saved the day. Market time out work when needed.

Law, courts and lawmakers

Beyond technology and market forces, others have turned to the law. But, with no regulatory response, they will have to fight on their own. Even in the case of a class action lawsuit claiming stock exchanges defrauded investors, the uphill climb will be long.

That class action argument is based on fraud. In that case, the argument becomes the claim that fraud happened when the exchanges let HFT in. And the suit names 7 exchanges. It tries to argue that once HFT gained access they could play their inside game.

As in any suit there must be a lead complaint. In this case, that lead complaint is, Providence, Rhode Island. In addition there are pension plans who have joined in what will be a very long fight. In that case, any settlement will be a long time coming. As well, in the suit, the named exchanges include BATS Global Markets, Nasdaq, NYSE and others.

Federal suit alleges misdealing and fraud by exchanges

According to the suit, exchanges that developed and sold HFT services, violated federal law. Exchanges offering those high priced services gave advantages to HFT. As a result, the advantages given to HFT by exchanges also barred and harmed investors. Consequently, that amounts to a manipulation of investors. According to the suit, that is illegal.

In addition, multiple other jurisdictions are contemplating legal actions. However, for our purposes one example is enough to make the point. The point being ​the substance of the legal argument against HFT. Without doubt, more lawyers and lawmakers are receiving calls and mulling legal responses to HFT. In that case, the numbers could grow.

In addition, several lawmakers have explored the issue. There is some talk of proposed laws. However, so far there is little but talk. Proponents of any such new law have a huge challenge to get both lawmakers and public support for the issue.

Understanding HFT is a complex challenge to nail down. It is far from black and white. Few politicians have any interest. Few investors understand it well and fewer members of the public know or care. Being realistic means expecting little to come of talk of legal actions.

In my expectation, lawyers will keep busy for years with little to show for it. I believe they will deliver little in the way of market changing effects.

Tax possibilities raised when markets technology and laws respond

That brings us to the taxing ideas. Lawmakers in several jurisdictions have expressed interest in taxing HFT. So far there has been no widespread understanding or support. Few lawmakers, happy to accept generous campaign funding, have motivation.

The case for financial transaction tax

But, to cover and understand the issue of proposing a HFT tax, we should discuss the basis of tax on trading. Most versions of proposals to tax HFT involve a Financial Transaction tax (FTT).

FTT means taxing ​each trade at a very low tax rate. The amount of any such tax would slide a small thin shave based on the transaction amount. Doing so would or could quickly more than wipe out the thin profit margins of most HFT. Most HFT trades produce less than one basis point profit. It takes 100 basis points to make 1%!

Backers of FTT say it produces revenue while cutting down stock market speculation. Some fans of FTT suggest it increases economic efficiency. Tax supporters also claim it dampens increased volatility. It does so by stopping unnecessary HFT while raising revenue. Most FTT advocates see HFT as an evil to be fought with this revenue tax grab. Imagine! A tax doing good for investors!

I am certainly not convinced a tax that stops HFT would do the deed and go then away. Rather, it likely would move in for a good long stay which would change markets. For investors that could certainly turn into an unwelcome unintended consequence.

Others argue that a FTT offers a way to stop HFT from rigging, market manipulation and investor abuse. They say bringing HFT under control would cut speculation, profiteering and stabilize stock markets. There are just as many opinions with opposing views. Who knew a tax could be so good or so bad!

Financial Transaction Taxes in many markets

There are considerable amounts of academic research and economic opinions around FTT. Such a tax is not new territory as it has been done before. For example, FTT exist in Australia, Belgium, France, Italy, South Korea, Switzerland and the UK.

One result of that tax action is those same markets are not HFT hotbeds. If may be a challenge to tie cause to effect but it certainly could be that the FTT be the reason. That makes on one think that U.S. and Canadian markets could benefit. However, I do not see a FTT happening any time soon in North American. For most North American politicians, HFT remains an obscure issue.

Still, FTT tax proposals keep coming but seem to get little public interest or support. How would FTT play out for North American markets? Opinions are many, facts are few, so I don’t know!

As far as I am concerned, arguing tax policy does nothing to advance our understanding of HFT. So we have made the points, first, FTT exists in several jurisdictions. Second, North American FTT proposals have all come to nothing, at least so far.

Tax proposals prompt perpetrator howls

Any North American FTT proposal generates a chorus of protesting howls. The groans come from the HFT wizards, their industry partners and a herd of paid apologists. Their voice is the industry association, Securities Industry and Financial Markets Association (SIFMA) who leads the chorus of complaints.

The SIFMA song runs:

Anyone believing this group or anyone associated with HFT, works for investor interests, believes in Santa. Still, few anywhere volunteer to pay more tax. And no surprise, the only tax SIFMA favors is the one getting put in HFT pockets.

Costs that HFT now impose across markets is like a tax that goes into the pockets of HFT wizards. Understandably they see that as good. However, that skim would be gone with any FTT.

A FTT would take that skim and put it in the public pocket. Naturally, according to HFT and their supporters, that would be bad. SIFMA also warns a FTT would reduce liquidity and impair market strength.

It remains unexplained why HFT costs imposed across markets avoids having the same impact this bunch complains about. Amazing that the effects of a cost they impose is not a problem. However any tax for the public purse is bad! Hmm...could anything be wrong with this picture? Perhaps these HFT warnings should be added to the many HFT misinformation myths prevously covered in Lesson 11? 

Tax proposals, problems and regulation

The legal, regulatory and industry insider protective wall that shelters HFT, has more cracks. Those cracks are denied by the gang protecting HFT. That bunch correctly views any FTT or regulation proposal as a threat. They are not concerned about investors or even markets but are very concerned about any threat or risk to the scheme producing a lucrative stream of HFT profits.

Virtually any FTT would end the HFT skim of tiny profit made in millions of transactions. In contrast, regulation could be challenging and expensive. But a tax would be simple.

Any proposed action would receive the normal HFT response. Lawsuits! These guys love keeping lawyers busy. And billions generated by the scheme make sure their revenue flow can fund unlimited legal actions.

Any large HFT industry response could keep law schools busy producing eager lawyers! Legions of legal beagles would respond to fight any significant regulatory change! The mind boggles!

SEC securities transfer tax

Anti-tax arguments takes a hit when considering how the SEC get funded. That happens from a securities transfer tax without a problem. As the U.S. now funds the SEC that way, a​n FTT could be mad as a simple addition on the transfer. 

As a result, presto, we have a simple adjustment to quickly produce a real time FTT system! Also worth considering, financial services as an industry, has an outstanding history of accurate record keeping. And that all gets done in real time with huge data feeds.

By taking advantage of the existing system, a FTT could be easy to administer and audit. As a regulated service by regulated parties, adding this requirement would be easy. It would have no significant bureaucracy or infrastructure needs!

Easy tax collection all but in place

Costs and complications of collecting a FTT get offered as further objections. Suggesting FTT creates the need for new bureaucracy or infrastructure are red herrings. Just use the working system that is now in place.

The existing system works just fine. So adding a FTT function would be a low cost item. To make a FTT happen could become a clearinghouse process addition. That could be accomplished by adding a tax collection function. 

The clearinghouse tracks every buy and sell transaction. That means tax collection is all but in place. Adding FTT collection would be easy. That could produce a low cost, easy to administer, well tracked system.

Regulators win on a spoofing penalty as markets technology and laws respond to high frequency trading

The SEC actually recorded a rare regulatory win! Tower Research Capital, a HFT firm, agreed to pay $67.4 million in a spoofing case. That rare case was brought by the Justice Department and the Commodity Futures Trading Commission.

In the settlement of that case, the penalty is part of a deferred prosecution deal. That settlement deal covers some 2012 and 2013 actions. Those actions happened over some 6 years before the settlement agreement.

Even considering settlement of this bogus order case, few enforcement actions interfere with HFT activity. In fact, any hint of action brings obstructive resistance. That obstructive resistance come from the HFT firms and their allies. For example, HFT firms even take aggressive action against proposed research into HFT. Understandably, they have no interest in tolerating research that could document the market tilting and investor abuse of HFT. In any event, HFT fights every step of the way.

SEC proposed review of trading rules meets HFT resistance

A HFT review preview gave the SEC and anyone paying attention, a look at how HFT responds to getting a close review. It happened at the end of 2018. Then the SEC proposed to test the effects of incentive schemes.

In response, HFT and friends launched lawsuits against the SEC. That review was an attempt to examine incentive schemes in wide use by U.S. exchanges. Those rebates also tie in the NMS rules.

For example, SEC immediately met stout legal resistance proposing to research stock market trading incentives and costs. They cited that the system had become expensive as both data and trading costs escalated. As such review was a threat to HFT profits so was opposed. Tilted or rigged markets, fair trading, transparency or investor abuse were of no concern.

The SEC proposed examining the costs of both data and trading. In effect, it proposed a review of investors, brokers, exchanges and HFT money-making schemes. The intention of the SEC was to give Reg NMS a good review. The goals were to first, document if NMS works as intended and second, discover ways to make NMS better.

In brief, NMS rules increased market complexity and division. That was the result of being blind to reality. Remember, NMS rules did not consider how technology changed markets.

Business practice, technology and time are factors in play that NMS does not consider. In a nanosecond world it gets very complex, very fast! Exchange themselves evolved beyond the traditional coop or utility like structure. They became for profit business happy to invent services and charge premiums. As covered in the early lessons on this course, data premiums rapidly evolved.

SEC knows that trading rules, the passage of time and technology are all changing factors. For example, there are new exchange developments, dark pools and insider dealings to review. In response, expect HFT to do what they always do. And that is obstruct in every possible way and launch lawsuits.

Those strategies keep the HFT gravy train going while pushing off any action that could bring their party to an end. It seems natural for the HFT gang to call any SEC action a conflict of interest.

For background on Reg NMS, incentive schemes and rebate programs are discussed in Lesson 8.

Now we see exchanges emerging to serve interests enabled by changing technology. As an example, the new exchange MEMX Members Exchange. Established to skirt high data costs on established exchanges.

In such an evolving environment the SEC struggles to keep up let alone be ahead of such change. Passage of time, technology changes, new exchanges, dark pools, insider dealings. They are behind what is going on. More interesting times are ahead!

Grassroots petitions, appeals and whines offer little hope

There are grassroots movements against HFT investor abuse. But as markets, technology and laws respond, individual small investors have little impact. From time to time various people propose doing something about HFT abuse. And while they are well meaning individuals, politicians or organizations, I expect little to come from it.

Should you get involved? I say don’t bother. The regulator cavalry will cheer you on but never show up for the fight. You are on your own. Save yourself from the drama and time burn.

Time and energy burned produces no return or any possible positive outcome. Rather, spend it on researching productive investments for your future. That will produce a lifetime of returns.

That far better and more profitable use of your time will pay off for you. Doing that offers both more rewards and greater satisfaction. I write these words as someone with years of experience. That includes involvement with security commissions, politicians, stock market regulators and compliance officers. I urge you to make better use of your time.

After more than a decade of HFT activity, only the IEX Group got their analysis right. After doing the research they concluded that only market forces could deal with HFT. That was the only practical way to bring about real change to HFT activity.

Lawmakers and regulators that matter are going to do little or nothing about HFT. Only market forces can and will produce significant change. After the application of market forces, change will happen.

Once the issue passes we will see politicians and regulators show up. At that time, they will finally show up, take a bow and declare their contribution essential. Then we can all go home. But until then, use the strategy from the next lesson to deal with HFT.