HFT-Limiting Experiment Underway in Germany

Germany’s Bundestag voted Thursday, February 28, approving a bill aimed at limiting the abuses of high-frequency trading.

If you’re a pessimist, you are even now muttering, “we’re from the government, and we’re here to help.”

If you’re an optimist, [and one who lives, invests, and seeks alpha for the most part outside of Germany] you may be happy to have Germany undertake an experiment in this respect. Other countries and their regulators may well observe how this initiative plays out and make more informed decisions themselves as a consequence.

There are also likely to be those who will differ from Germany even within the European Union. Meanwhile, the globe is a big place, and there are lots of laboratories in which the critical questions of exchange structures and infrastructures may yet be tested.

The Problem Defined and Addressed

But let’s look at the news from Germany:  The problem, as the government there saw it, was that firms that traded exclusively on their own accounts (including most HFT traders) didn’t fall under the authority of the Federal Financial Supervisory Authority (BaFin). The new law solves that problem, explicitly letting BaFin supervise high-frequency trading that it otherwise couldn’t have touched.

A document posted by BaFin in November described the pending bill in an English-language outline, here.

Intriguingly, the bill would require exchanges to mandate a minimum tick size and order-to-trade ratio on an instrument-by-instrument basis.

Chancellor Merkel’s ruling coalition believes that the bill will help prevent flash crashes. Some opposition politicians, though, pressed unsuccessfully for something more explicit, such as a 500 millisecond mandatory waiting period between an order and its cancellation.

Why Germany?

There is something a bit ‘off’ here. The U.S. regulators have done nothing at all in response to a series of U.S. based exchange-related crises: the Flash Crash of May 2010; the failed effort at an IPO by BATS in March 2012; the snafus associated with the Facebook IPO in May 2012; and the bizarre trades at Knight Capital’s market-making unit last August.  The regulators continue to study possible responses, and actions based on that study are of course possible. But that is as far as it has gone.

Yet the above is a list of U.S. based difficulties. Nothing analogous has happened in Europe thus far.

I spoke Monday, March 4, to David Weild about Germany’s action and related issues. Weild, a former vice chairman of NASDAQ, now the principal of Weild & Co., has been quite active of late in making the case that the capital formation system in broken and needs repair, particularly in order to get necessary investment funds to small and medium capitalized businesses.

“They’ve clearly been looking at what’s occurred in the U.S. markets,” he says of the Germans.  “This is a global issue, since they’ve increasingly homogenized global market structure.”

In the U.S., according to one school of thought, the reduction of the minimum tick size through the 1990s has had a lot to do with the dysfunctions.  As the size between one tick and the next narrowed, spreads fell, and displayed liquidity at National Best Bid and Offer also fell. According to a view associated with Themis trading LLC founders Sal L. Arnuk and joseph Saluzzi, this made “pinging and sniffing for order flow” a lot easier, and smoothed the path for robotic traders.

Tiny Tick Sizes

When the robots get things wrong, they do it too quickly for any timely human intervention, leading to the sort of incidents listed above.

I mentioned to Weild that so far as I knew this move to smaller tick sizes is a U.S. phenomenon, not (for example) a German one.  He differed.

“There are tiny tick sizes all over the world,” he said. “Once you start moving away from quote-based execution, and toward electronic execution systems, it is then that tick size becomes absolutely critical.” This basic pattern two-part pattern has played itself out around the world, although the historic specifics differ.

Weild and I also spoke about the idea of a mandatory wait period after a bid. He said, “Such a regulation can cut down on certain types of gaming of the system so it can help.”  In particular, bids that are immediately cancelled can floor the system with illusory traffic that makes both abuse and error a good deal more likely.

My Humble Opinion

I’ll interject here that in my own view, if a problem began with a regulatory dysfunction, then the best way to address it begins with a roll-back there. If the world’s markets are broken in significant part because regulators pressed for smaller tick sizes, then reform energies should target that point.

What is hopeful about the German experiment is that at least in part it does address that point. Ideally, though, issuers via a vote of their board of directors should be able to specify their own tick size, and the exchanges will adapt their own rules accordingly.

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