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HFT detractors believe the strategy has resulted in blatant market manipulation. One of those manipulative tactics is an abuse known as “quote stuffing.” Massive amounts of orders are entered into an exchange, but then quickly withdrawn before any trades can be executed, a practice which is ostensibly illegal. But because the super-computers of competitors are still forced to process the data, they are slowed down, losing their competitive edge as result. Columnist Tyler Durden of Zerohedge.com explains:
If you could generate a large number of quotes that your competitors have to process, but you can ignore since you generated them, you gain valuable processing time. This is an extremely disturbing development, because as more HFT systems start doing this, it is only a matter of time before quote-stuffing shuts down the entire market from congestion.
These stuffed quotes can also have “shapes” that effectively manipulate the National Best Bid and Offer (NBBO) requirement — the SEC rule that brokers must guarantee customers the best available ask price when they buy securities, and the best available bid price when they sell securities. As a result, detractors contend, much of the so-called liquidity provided by HFTs may be totally illusory.
Market regulators are apparently more concerned than ever. Last Friday, it was revealed that the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission want high-frequency trading firms to turn over details regarding their trading strategies — and, in some cases, their highly secret and often very expensive algorithms as well. “It’s not a fishing expedition or educational exercise. It’s because there’s something that’s troubling us in the marketplace,” said Tom Gira, executive vice president of FINRA’s market regulation unit.
The SEC has ostensibly adopted some new rules to prevent a repeat of the May 2010 flash crash mentioned above. Large traders, as in a person or company whose transactions in exchange-listed securities exceed two million shares or $20 million on any day, or 20 million shares or $200 million per month, will be assigned unique ID numbers. The traders will then supply those numbers to their broker-dealers, allowing the SEC access to those records if something goes amiss. The SEC is also proposing similar measures for dark pools, which are alternative trading venues that find bid/ask matches for blocks of shares without revealing the orders or the identities of the institutions involved. “Circuit breakers,” which would temporarily halt trading in stocks that fall or rise 10% or more in five minutes, were also part of the mix. But those rules only apply to the S&P 500 and the Russell 1000 exchanges currently.
Critics consider these measures largely toothless and outdated, and unable to prevent another flash crash from occurring. Both articles referenced here accuse the SEC of institutional paralysis and calculated ineffectiveness, respectively.
Perhaps the SEC might want to examine suggestions put forth here and here. The former would be the imposition of a “minimum active quote latency,” meaning no one would have a speed advantage over anyone else. This would eliminate the rationale for quote stuffing, which in turn, would essentially eliminate HFT. This would undoubtedly incur the wrath of many traders. The latter is a less onerous proposal, aimed at curbing quote stuffing by imposing a tax on order cancellations, thus discouraging the practice.
Whatever FINRA or the SEC does, one thing is certain: unless some sense of trust is restored into the market, investors will flee. After the 2010 flash crash, investors pulled $13.4 billion out of the market. And such skittishness is not limited to small investors. Consulting firm Grant Thornton reveals a 15-year decline in the number of initial public offerings by small companies.
A broker who wishes to remain anonymous explained that the kind of volatility we have seen in the market recently, such as the unnerving intra-day swings of several hundred points in both directions, may be the “new normal” within two to three years. Stock market volatility is measured by the “Volatility Index” (VIX), which hit a 52-week high following S&P’s downgrade of America’s credit rating. Such ongoing volatility, the broker contends, would drive most small investors, whose portfolios represent their retirement nest eggs and other critical savings, out of the market completely.
For the record, the official explanation regarding the flash crash on May 6th, 2010 is that the cause was a single firm’s attempt to sell $4.1 billion in specialized futures contracts. This set off a “cascade of selling” by HFT super-computers, in turn causing one of the most volatile trading days in market history.
Joe Saluzzi of Themis Trading LLC, who characterizes HFT traders as the “new insiders” on Wall Street, gets to the essence of the problem. “Valuation [of a company] is irrelevant,” he warns. “It’s all about just moving the price up and down the ladder all day long. Each day is new. Each day starts fresh. So, you have to question the true valuation of the markets now.” That’s a troubling statement, which begets an equally troubling question: what does the future hold for stock exchanges whose principal reason for existence, aka the capitalization of companies, has become largely relevant?
The daunting new reality? Technology has likely turned trading activity into little more than a sophisticated computer game.
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