Deutsche Bank and Barclays, writes The Wall Street Journal, are on the verge of signing a unique agreement with the DFS, which stands for New York's Department of Financial Services. The banks have accepted the installation of monitors, managed by independent bodies, which will monitor possible trade manipulations on the foreign exchange markets. This is to gather evidence on alleged practices to the advantage of hfts, the high frequency traders, to the detriment of other operators.
In short, the big names in world finance are treated like supermarket cashiers smelling of theft. Even so, the authorities are trying to bring dark pools under control, i.e. private stock exchanges managed by large banks that make large transactions on shares or other financial products possible in absolute anonymity. And opacity. To the advantage of the new major protagonists of the price lists, the hfts, which now control more than half of the exchanges.
In recent weeks, three major institutions, Deutsche Bank, Crédit Suisse and UBS, have admitted that they are at the center of investigations conducted by the SEC into the mechanisms in use at the dark pools. The target? Demonstrate that the competitive advantage of electronic traders, capable of replicating millions of operations within infinitesimal time spaces, takes the form of a colossal insider trading capable of upsetting the rules of the market, starting from the mechanisms of formation of the prices of the securities. It's a fascinating game, made popular by Michael Lewis's best seller dedicated to the rise of the first hfts, capable of mobilizing billionaire investments just to shorten the data transmission speed from Chicago to New York or London by a few tenths of a second. Will the use of monitors be able to bring the technological leadership of Hft systems under control? We are publishing, courtesy of the Aiaf magazine, the analysis and therapies suggested by two Italian scholars who are experts in the field: Giovanni Bottazzi, former head of the statistics office of the Milan Stock Exchange, and Alfonso Scarano, former vice president of financial analysts.
HFT: ULTRA-FAST EXCHANGE ORDERS OR MARKET MANIPULATION?
Ultra-fast stock market orders will be a problematic and disturbing presence until their nature and consequences on the fairness of the market are well clarified, because many suspect that the game is rigged in favor of HFT operators.
In a few years from the United States a transformation of the methods of production and transmission of orders has spread to the stock exchanges of the world in a practice known as High Frequency Trading, or simply HFT, implemented by a small circle of technologically very gifted operators. Its main feature is its surprising speed which allows competitive advantages of the order of thousandths of a second compared to other operators. Super-fast computers, programs and algorithms are entrusted with "automatic" decisions that are triggered upon the occurrence of pre-established "market" conditions. Hence the very short dispatch of a large number of orders, ie high frequency orders, for which human intervention is reduced to the programming phase.
By "market" we mean that traditional part of it which is capable of autonomous life, carrying out the typical function of establishing the price of securities through the well-organized meeting of supply and demand decided on the basis of financial considerations regarding the profitability prospects of the companies broadcasters. HFT operators take advantage of this socially useful market: they scrutinize its discontinuities, creep into the interstices of time and transform them into profit. It is therefore legitimate to qualify the HFT as a parasitic activity: on the one hand it does not bring new financial information about the value of the securities, but only exploits that deduced from the market itself; on the other hand it does not contribute to the assumption of financial risk, given the practically zero investment times in the few cases of transformation of HFT orders into real exchange contracts. In short, in the HFT practice the distortions of a disharmonious development of the financial markets are enhanced in which:
– the rapid evolution of technology has transferred complex decision criteria from man to machines, almost eliminating the time dimension; but the regulation struggles to keep pace, despite the principles of correctness and efficiency of the financial markets which had inspired their organization and functioning for many decades;
– the high costs of the technical structures necessary for the HFT activity are a barrier to the entry of new operators. Thus the market tends towards an oligopoly, where a few large entities operate across the board and at an international level;
– the Stock Exchanges did not initially understand the dangers inherent in the HFT phenomenon and, subsequently, to face the competition from alternative trading systems, they made the best of the bad situation on which they now largely depend, given that the HFT-branded operations cover over half of trade in the USA and slightly less in Europe; so much so that it is necessary to grant tariff subsidies to HFT operators to ensure a greater volume of orders entered, despite the tiny share that ends in actual trades.
The competition between operators takes place above all in the technological field and requires continuous updates in software and hardware. All this increases costs and, in the face of the few beneficiaries, oppresses the rest of the market. Awareness of the situation is equally asymmetrical, because among the very many injured, few really grasp the terms of the problem and its relevance for good finance, the one that serves the real economy. The problem is therefore cultural and also political: politics finds it difficult to devote itself to this matter, which is so markedly technical and in the hands of a few, remaining easily captivated by the interested statements of that small minority of beneficiaries which nonetheless boasts powerful persuasive means.
* * *
The never dormant question about the true nature of HFT, its legitimacy and its consequences periodically returns to the attention of the media. The most recent occasion was, in the spring, the publication in the United States of Michael Lewis' book “Flash Boys, a Wall Street Revolt”. But a revolt against what? To understand it, it is necessary to go into some more specifically technical aspects.
For each listed security, the Stock Exchange's electronic platform keeps an order register, known as the trading book, continuously updated. It collects the negotiation orders, PDN, purchase and sale orders, and sorts them by priority of arrival time and price, in a ranking of convenience for a counterparty. At the same price, the proposal that is first registered in the book is successful. Hence the race for fast computers, for optical fiber transmission lines, which allow speeds close to that of light in a vacuum, even for positioning electronic equipment in the premises of the Stock Exchange (co-location). But not everything is aimed at truly carrying out the exchange in the shortest possible time: the higher speed allows precious advantages above all in terms of information. There are various strategies adopted.
Perhaps the least contested one is “market making”. Having verified in the trading book, for a certain security at a certain moment, a certain price interval (spread) between the best offer and the best ask, the HFT systematically interposes negotiation proposals both for purchase and for sale just better than those found. If the contract is made in purchase, and immediately after the same occurs for the one in sale, the HFT operator sees his position canceled within fractions of a second and achieves a small differential profit; which, however, can be repeated many times and for many titles. It is the parody of the market maker, because it erodes the margin for the real market maker accredited to the Stock Exchange with a binding contract in terms of quantity and persistence of orders. The HFT operator, on the other hand, remains free to evaporate from the market if he judges the conditions no longer favourable.
Among other techniques considered of dubious legitimacy we mention layering and stuffing. With the first one tries to accredit false beliefs on the momentary trend of the market through the massive entry of orders from the supply or demand side, orders which, however, are immediately canceled as soon as the opportunity is recognized. With the second strategy, the operator invades the market for the sole purpose of slowing it down, with orders that will not be concluded in a contract.
However, among the most directly manipulative strategies are those of front running, configuring the theft of information contained in a primordial order. It is the updated version of the ancient original "skimming the order" by the intermediary, anticipating it in the execution to profit from it; but here the HFT has no intermediation mandate and is only the third wheel. This strategy harms the issuer of the primordial order and is legally prohibited everywhere; however, it is difficult to identify and pursue it concretely.
Front running HFT occurs if someone intercepts the order before it is displayed on the order book, i.e. before it is known to the market. Therefore, it is not enough for someone with greater speed to simply "read the book" before the others; even if, obviously, its chance of success increases by reducing the reading time of the primary order in the book and of the consequent automatic reaction, enjoying at the limit of a privileged position located right in the building of the Stock Exchange. Since it is not possible to anticipate the order of others that has already arrived at the book, its interception must take place first, and for this it is necessary to "see" the order of others at the start. If this happens, good rules are not respected and the market is not fair. But how can this happen?
Paradoxically, one of the rules imposed on the market intervenes, the one that obliges the best execution (in Italy it is the dynamic best execution, in the USA it is known by the acronym NBBO). Precisely this, by forcing the Exchange to retransmit the order received to other trading platforms which it cannot immediately execute under the best conditions, seems to be of great help to the casual practice of HFT front running. The timing of this turnaround of the order in fact allows someone to intercept and anticipate it.
It is against this form of market pollution that the "revolt" announced by the author of the aforementioned book arises. It is not just a matter of a moral rejection in the face of a picture of the US financial market heavily conditioned by the systematic "predation" of the original order through HFT, as portrayed by the Author through the words put into the mouths of some super-experts in the sector; the Author also exposes their reaction to counter it. The technological gimmick is ingenious and consists in the management of the "latency" times, i.e. the transmission of telematic orders. An innovative system has been created, called IEX, which regulates the latencies with the various platforms to which orders can be transmitted for execution in order to cancel the time advantage left to third parties which could interfere with the HFT front running. Revolt is thus a practical barrier of defense against more directly manipulative intrusions; and the book is a good advertisement for it. But both the open denunciation and the news that the market is starting to react autonomously, autonomously developing antibodies against the pollution that mortifies it and thus curbing the mad race towards uncertain landings, on the edge of the thousandths, are both important and positive. and even millionths of a second.
On the other hand, on the front of the controls and sanctions of the abuses of the HFT front running, investigations are needed to identify the buckling point in the chain of transmission of negotiation proposals. Here it seems essential to acquire and study the service contracts (SEL - Service Level Agreement) stipulated by the Stock Exchange and by other electronic contracting platforms. But then subtle analyzes are needed with adequate technological equipment, which up to now has been manifestly lacking in the supervisory bodies.
As regards the theoretical evaluation of the positive effects recognizable to HFTs in terms of liquidity, in exchange for which some stock exchanges grant tariff rebates to operators to increase activity, doubts should prevail, given that this liquidity is notoriously illusory and ephemeral, ready to evaporate just when it would be most useful to the market. On the other hand, the drive towards incredible oversizing of the IT superstructures of the Stock Exchange is, on the other hand, absolutely certain, excessive if compared with the actual trading volumes. The cost overload ends up weighing on those operators who really intend to trade securities. These suffer both the damage of higher tariff charges and the insult of the constant predatory attack of the HFT brand. Thus some of them are gradually expelled from the market, again verifying Gresham's law according to which good money is driven out by bad money, which instead consolidates.
