High Frequency Trading Regulation Should Promote Deep Markets

Monday, August 30, 2010

robot on keyboardSenator Ted Kaufman has been a leader in critically assessing the impacts of high frequency trading on today's financial markets. Kaufman wrote a letter to the SEC on August 5th highlighting key issues the Commission should review. Most notably, Kaufman argues that "regulation should aim not to facilitate narrow spreads with little size or depth of orders, but instead promote deep order books". A deeper market will create greater stability and confidence for investors.

The purpose of equity markets

Kaufman starts his letter by restating what the Chairman of the SEC, Mary Shapiro, has said are the market's two primary functions. First, "capital formation, so companies can raise capital to invest, create jobs and grow" and second, "attracting and serving long-term investors to help facilitate the capital formation process". While this is clearly the underlying purpose of financial markets, traders have long served the role of making markets and providing liquidity to improve the efficiency of moving capital between stocks and markets.

Rethinking years of regulatory goals

For a long time now, accepted wisdom has been that regulators should aim for lower transaction costs by fostering competition between brokerages for commissions and by improving liquidity to narrow spreads. Yet, is it possible we have reached a point of diminishing returns?
Wider spreads with a large protected quote size on both sides may facilitate certainty of execution with predictable transparent costs. Narrow fluctuating spreads, on the other hand, with small protected size and thin markets, can mean just the opposite -- and actual trading costs can be high, hidden and uncertain. Deep stable markets will bring back confidence, facilitate the capital formation function of the markets and diminish the current dependence on the dark pool concept. At a minimum, the Commission must carefully scrutinize and empirically challenge the mantra that investors are best served by narrow spreads. In reality, narrow spreads of small order size may be an illusion that masks a very 'thin crust' of liquidity (which leaves market vulnerable to another flash crash when markets fail their price discovery function only next time within the bound of circuit breakers) and difficult-to-measure price impacts (that might be harmful to the average investors and which diminish investor confidence). [emphasis mine]
The narrow spreads fallacy can be witnessed by any active market participant executing orders. Sean Hendelman and I previously proposed an order cancellation tax which we believe would go a long way in exposing what is the real, wider spread and make the bid and offer more dependable and thus more efficient in the long run.

While a good number of studies have been released that purport to show that spreads have narrowed in the most liquid names, it is well worth considering whether that narrowing has actually improved the price discovery process. Meanwhile, opponents of HFT simply argue that the minor narrowing of spreads in already liquid stocks is irrelevant and the true problems are widening spreads in thinner securities. In that case, it is the worst of both worlds: wider spreads and less dependable quotes.

Explicit versus implicit costs of trading

Kaufman continues in his "Market Structure Solutions" attachment to the letter with nine wide-ranging, comprehensive suggestions, several of which I will discuss in future posts. On the spreads issue he succinctly summarizes his belief:
While some regulations might widen spreads and raise the explicit costs of trading, those outcomes along should not disqualify such rules from being considered. Indeed, policies designed to protect large quote sizes on the bid and offer and to mandate or incentivize significant resting liquidity be provided at multiple price points would result in wider spreads, but also offer greater certainty of execution and make trading costs more predictable and transparent for investors. Simply put, it may be better for investors to pay the spread they can see than the price impacts they cannot see or effectively measure. [emphasis mine]
It is crucial to understand that the costs of trading are both the explicit upfront fees as well as the implicit expense of poor execution of an order. Human traders have recognized the difficulty in executing large orders because of illusory bids and offers that cancel at a moment's notice coupled with the free-riding high frequency traders that snatch up liquidity alongside in hopes of profiting from the larger trader moving the price. The SEC should examine both costs and design regulation around reducing, or at least making transparent, total trading costs.

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: No relevant positions.
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