High Frequency Trading What does it mean for Plan Sponsors? Zeno Consulting Group, LLC May 11-14, 2015

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1 High Frequency Trading What does it mean for Plan Sponsors? Zeno Consulting Group, LLC May 11-14, 2015

2 Table of Contents What is High Frequency Trading? Is High Frequency Trading good or bad? Proposed Solutions Should Plan Sponsors be concerned? Zeno s recommended Check List 1

3 What is High Frequency Trading? High Frequency Trading ( HFT ) was brought to the attention of the general public in early 2014 by Michael Lewis book Flash Boys. Not yet formally defined by US regulators, but typically entails: the use of very sophisticated computer algorithms, high-speed communication components, and geographic proximity to trading centers in order to implement trading strategies as quickly as possible. Two important distinctions from the typical investment manager used by plan sponsors: a. Most HFT invest their own money (rather than that of outside clients); and b. Most HFT firms tend to assess their profitability daily. Key Point: HFT is only possible in a fragmented market (i.e. multiple exchanges that securities can be traded on), and an obligation that trades be executed on whichever exchange has the best price, at that particular point in time. 2

4 What s all the fuss about? The typical predatory HFT strategy entails: a. Enormous volumes of small intra-day trades (essential to generating significant revenues, without making large risky trades), b. Queue priority (essential to executing trades under Reg NMS), c. Flipping in and out of positions almost instantaneously (essential to minimizing market risk), and d. Rebate capture (essential for making an overall profit given the short-term holding period and the market s tight Bid/Ask spreads). This strategy is only possible if HFT firms can obtain, process, and successfully react to market-data information very quickly. Just how fast is HFT??? 3

5 Important Point: No consensus if HFT helps or hurts Arguments against HFT: The super-fast posting and cancelling of HFT quotes provides a false sense of liquidity and price discovery (particularly for institutional-sized orders). At its core, HFT adds little in way of true liquidity, and is intended to essentially step in front of institutional orders (albeit, not technically front running ). Many HFT trading practices are designed as winner take all strategies in which the firm with the fastest process wins every time (incenting a technology arms race among HFT firms to be the fastest). HFT firms and the exchanges that cater to HFT firms, collude to develop features (such as special order types, co-location, direct data feeds, and unique maker-taker fee arrangements), in an essentially exclusive and non-public manner. Broker/Dealers who operate Dark Pools and simultaneously maintain internal HFT funds (that trade in those Dark Pools), have an inherent conflict of interest. All of the above (in combination), contributes to general erosion of confidence, and loss of faith, in the integrity of the markets. 4

6 At the same time Arguments for HFT: HFT is simply a product of the fragmented market-structure engendered by Reg NMS (50+ exchanges, Dark Pools and other ATSs), which created an environment where advanced algorithms and speed in communicating are at a premium. In many respects, this was the intent of Congress and the SEC. To wit: a fragmented marketplace is a prerequisite for competition, which in turn, fosters innovation and ultimately more efficient executions. Many if not most empirical studies suggest that HFT quotes (even if fleeting), on balance, result in lower overall trading costs by providing liquidity and narrowing the bid/ask spread. HFT further provides a higher level of price discovery for investors. Explicit trading costs (i.e. commissions) have been reduced to unprecedented levels. Curbing HFT may therefore result in higher costs and lower liquidity. For example: A recent study on Canadian regulations designed to curb HFT, found that HFT activity fell as a result of the regulations. However, Bid/Ask spreads correspondingly widened almost ½ bp for every 1.6% reduction in HFT activity. Another study found that France (who enacted anti-hft legislation in 2012) has seen its market share of European equity trading fall 88%. 5

7 Various proposed industry solutions include: Don t do anything, and let the current regulatory framework and free markets work. Improve transparency through increased disclosure by trading centers; and use sophisticated oversight tools (e.g. TradeDynamix s and Trillium s software), to enable smarter order-routing strategies. Incorporate randomized delays (of 0-10 milliseconds) between the time that posted quotes/cancels are received by a trading center, and when they are actually submitted to the trading center s matching engine. Use a standardized fixed delay (e.g. 350 microseconds) before notifying firms that quotes were executed. Conduct trades via Batched Call Auctions, on set time-schedules (e.g. 1 per sec.) at which time all quotes (submitted since the prior Batched Call Auction) would be reviewed to determine the best price. Charge a transaction fee (e.g. 1 ) for every quote, cancel, and/or trade. Reform or eliminate the maker/taker rebate pricing model. Limit the permissible types of orders used by Exchanges/Trading Centers. Increase the minimum tick-size from 1 to 5. Increase the speed at which the Securities Information Processor ( SIP ) consolidates the exchanges trade/quote information; and prohibit the selling of proprietary data feeds by exchanges. Require all trading centers and HFT firms to install Circuit Breakers, or Kill Switches (e.g. a 5 minute pause for larger cap stocks that fall 10% in the preceding five minutes). Require all HFT firms to register with FINRA and/or the SEC. 6

8 An issue upon which reasonable minds can differ Zeno feels intuitively, that HFT is neither all good, nor all bad. Rather, unlike the premise of Flash Boys, this is an issue upon which reasonable minds can differ. For example, the author of a 2012 study demonstrating that HFT tended to reduce trading costs (and cited by the SEC), published a second paper in 2014 suggesting that under certain conditions, HFT could increase trading costs. Zeno feels additional study and quantitative analysis of HFT is needed before final conclusions are drawn. Zeno is also mindful that crafting a regulatory solution to HFT (if one is needed) does not guarantee the achievement of the desired goals, and sometimes results in unintended and undesired consequences. Additional analysis will not only help clarify whether certain practices should be constrained, but also assist regulators in fashioning appropriate solutions. 7

9 And the SEC agrees! SEC mandate is to oversee and promote fair and stable markets. In this regard, since 2010, the SEC has been active in researching HFT, and making their findings available to the public. This includes: The establishment of a public website called MIDAS that publishes trading data previously unavailable or difficult to obtain; Approval of a new FINRA rule (which went into effect May 28, 2014) requiring Alternative Trading Systems (e.g. Dark Pools) to report their weekly trade volume and number of equity and bond trades. In June, 2014 SEC Chair Mary Jo White announced plans to investigate a broad range of HFTrelated issues, including new reporting requirements for ATSs regarding their operations (along the lines of what FINRA has begun doing); a Pilot Program exploring the value of increasing the minimum tick size; a review of whether Reg NMS s Rule 611 ( Trade Through ) has contributed to excessive market fragmentation; a new Rule that enhances the disclosure requirements of Reg NMS Rule 606 (broker order-routing practices); and working with exchanges to address how order and price data is released so as to not disadvantage the public. SEC Chair Mary Jo While also announced the establishment of a blue-ribbon Market Structure Advisory Committee. May 13 th was their first meeting and looked at Rule 611. Having said all that 8

10 Should Plan Sponsors be concerned? HFT presents both a quantitative and a philosophical question for plan sponsors: Whether HFT, on balance, causes their investment managers to incur higher trading costs. Whether HFT (or certain aspects of it) are eroding investor confidence in the integrity of our market system. For plan sponsors that don t run money internally, there is little direct action a Fund can take. HFT micro-market structure issues are more properly the province of their Fund s investment managers, the broker/dealers those managers use, and the trading centers where their trades are executed. However, plan sponsors should not ignore the effects of HFT. Rather, the key is investor awareness; and whether that awareness triggers due diligence oversight re: the tools and practices utilized by the Fund s investment managers. 9

11 Your managers should be on top of these issues! Greater transparency and oversight by: investment managers the broker/dealers they use, trading centers, and regulators is clearly needed. Managers should have informed views if HFT helps/hurts them; and how to manage the risks. Sophisticated trade cost analysis and venue oversight are becoming available to those who care. Sample Pre-trade HFT Analytics Mkt Alerts Sample Post-trade HFT Analytics Spoofing 10

12 Conclusion: Plan Sponsors have a right to expect their managers to be knowledgeable and employ smart order-routing strategies, that minimize the risk from HFT. A due-diligence oversight check list to ask your managers: Are investment decisions (including orders executed over several days) implemented efficiently, and obtaining best execution, for your account? Are managers making informed decisions as to which trading-venues to use (i.e. are they free from HFT price manipulation and/or predatory practices)? Are managers conducting due diligence on the order-routers used by the broker/dealers the manager uses (i.e. which venues are prioritized, the reasons why, and any ancillary incentives)? Are managers conducting due diligence on potential conflicts the broker/dealers they use may have (e.g. relationships with trading venues or HFT firms, proprietary dark pools and trading)? Are managers using quantitative TCA tools in determining how/when/where to route trades? 11

REGULATING HFT GLOBAL PERSPECTIVE

REGULATING HFT GLOBAL PERSPECTIVE Venky Panchapagesan IIM-Bangalore September 3, 2015 HFT Perspectives Michael Lewis:.markets are rigged in favor of faster traders at the expense of smaller, slower traders.