Earlier this month, New York Attorney General (NYAG), Eric Schneiderman, set out his stall with a scathing attack on high frequency trading firms and their practices. Describing HFT firms as ‘parasitic’ and comparing their strategies to “Insider Trading 2 .0”, the NYAG’s statement would have been music to the ears of financial luddites across the globe. But, even though that kind of rhetoric may have populist appeal, it is difficult to see how his proposals could ever achieve their desired outcome.
He suggests that many technology and information services should be curtailed because they allow HFT firms to gain an information advantage over everyone else in the market. These services include “exchange co-location datacenters, direct data feeds, high-speed switches and cables”. According to the NYAG’s press release, they allow HFT firms to “guarantee themselves enormous revenue and force large investors to develop complicated and expensive defensive strategies to conceal their orders from parasitic traders”.
The problem with this reasoning is twofold:
1) Arbitrage is not necessarily a bad thing: There is an assumption in the NYAG’s statement that all HFT strategies are predicated on scalping institutional fund managers – which we would dispute. Similarly, there is a suggestion that risk-free profit – aka arbitrage – is somehow damaging to markets.
Arbitrage is a fundamental aspect of financial markets, and has ancient origins that pre-date the existence of currencies, let alone securities or derivatives. Temporary mis-pricings naturally occur when the price of two, or more, related assets diverge. Being able to arbitrage away those mis-pricings is the sign of a healthy market. The evolution of technology has made arbitrage opportunities harder to capture. As markets have become faster, arbitrageurs have had to invest in more sophisticated technology to keep up. But trying to reverse that process would be futile.
2) There will always be information asymmetry: Arbitrage opportunities occur naturally because of information asymmetries. Traders and investors have always sought to be first to receive news that impacts the valuation of their holdings. That is why commercial information providers exist. Every newspaper, magazine or information vendor that charges for content seeks to differentiate itself from its competitors. They do this by offering some form of unique insight – by being first to carry a piece of information or analysis. 150 years ago, being first to deliver information could be down to your use of carrier pigeons to relay news from one city to another. Nowadays, it is often down to your use of technology, or your investigative / analytical strengths. But while the spread of Internet access has enabled information to be communicated much more quickly and extensively than ever before, it is impossible for everyone to receive and respond to the same information at the same time.
Where is the NYAG headed?
If NYAG succeeded in outlawing exchange co-location datacentres, trading firms with latency sensitive strategies would seek to host their algorithmic trading engines next to the nearest exchange Point-of-Presence. If they standardised all connectivity and outlawed direct feeds, firms would still compete over how well they could tune their systems to process and respond to the data. And banning high speed switches and cables? We may as well call for this ‘Internet’ thingy to be torn down.
Once we start to regulate the commercial provision of information services, we begin to head down a dangerous path. While the NYAG may have the noblest of intentions – trying to eliminate unfair advantages – the truth is that all commercial information providers could be seen to offer some form of unfair advantage. If I subscribe to the Wall Street Journal or Financial Times, I will have access to information before someone who doesn’t subscribe. Isn’t that unfair?
If we truly wanted everyone in the market to receive the same information at the same time, the only logical way to do so would be to have one highly regulated, potentially state owned, information agency. All of the content coming from that agency would be distributed freely to everyone at the same time (with some clever technology to equalise any differences in latency that naturally occur, because not everyone is in the same place). And anyone seeking to provide an alternative source of information that offered any form of advantage would be imprisoned.
Surely that isn’t a direction we want to be heading in? Commercial providers of information services serve an important purpose – keeping the market informed and better able to assimilate new information. The fact that they compete over the quality and speed of their information delivery is a good thing.
Rather than singling out specific technologies that are seen to offer an information advantage, surely lawmakers would be better off identifying and clamping down on HFT firms that really are front-running institutional investors, rather than assuming that is all they do. Otherwise, the risk is that new measures to curb HFT will only serve to trip up liquidity providers, and be to the detriment of the broader market.
As ESMA prepares to consult on technical standards detailing how MiFID II will impact automated trading strategies, what would serve us better is a reasoned debate based on proper evidence, rather than this kind of rhetoric.