The Securities and Exchange Commission has begun plotting how to curb abuses in high-frequency trading, as part of its broader effort to ensure that market regulations keep pace with trading realities.
HFT, as it is commonly called, now accounts for roughly two-thirds of trading volume in the equities markets. It is also a prime suspect in the “flash crash” that sent hundreds of stocks seesawing for 5 minutes on the afternoon of May 6—an event that deeply spooked investors and regulators alike.
One probable target of regulation will be “quote stuffing,” where traders enter thousands of orders and cancel them within a split second. In a speech on Sept. 7, SEC Chairman Mary Schapiro said mass cancellation of orders may sometimes be justified based on changing market conditions, but overall the SEC and other agencies will be looking carefully at certain practices to see whether HFT violates existing rules about fraud or other improper behavior.
Congress is also demanding action on high-frequency trading. Several lawmakers, including the powerful Sen. Charles Schumer (D-NY), have called for the SEC to implement a minimum quote duration—an idea Schapiro said the agency will consider.
That possibility set off alarms among several securities experts, who warn that a poorly constructed approach to minimum quote life could backfire and actually reduce market liquidity rather than preserve it.
“The SEC needs to be careful that it only penalizes market manipulators and not legitimate market-makers,” says Sean O’Malley, a former SEC lawyer who is now a partner at the firm White & Case. He (and others) say market-makers place thousands of simultaneous bids and offers for a security and then cancel them for a variety of legitimate reasons, such as managing capital risk.
On the other hand, quote stuffing simply to move the price of a stock in a certain direction, or to create the appearance of market activity when none really exists, “is market manipulation, not market-making,” O’Malley says. He interprets Schapiro’s comments to mean that the SEC is worried that a high number of canceled orders “could have a distortive effect on the market, even if there’s no intent to doing something nefarious.”
Former SEC Chief Economist Lawrence Harris, now a finance professor at the University of Southern California, says that a required minimum quote life could have a substantial effect on market activity, depending on how long that required lifespan is.
“The SEC needs to be careful that it only penalizes market manipulators and not legitimate market makers.”
—Sean O’Malley,
Partner, Capital Markets Practice,
White & Case
“If dealers, including high-frequency traders, aren’t allowed to cancel quotes, they won’t quote for as much size, and they might start quoting more hidden orders, which means they won’t offer as much liquidity to the market,” Harris says.
O’Malley
O’Malley agrees. He says market-makers won’t place new trading orders until existing ones have either been executed or lived long enough to be canceled. “How much liquidity would be impacted is hard to say, but there clearly would be some impact,” he says.
Schumer and his supporters in Congress, however, say the practice is serious enough to merit regulation regardless. In a Sept. 7 letter to Schapiro, the senator said he is “increasingly convinced that the costs of reducing execution speeds by an extra microsecond here or there outweigh the benefits in terms of allocating capital efficiently.”
Hunsader
Among those advocating a required minimum quote life is Eric Hunsader, CEO of quote-data provider Nanex. His company published a report in June that said quote-stuffing “played an active role” in the May 6 flash-crash and said some high-frequency traders placed large numbers of orders simply to keep competitors busy processing them.
Hunsader says a required quote life of 50 milliseconds—unless a quote is executed or the party that put it out wants to improve it by making the bid price higher or lowering the offer price—would eliminate quote-stuffing without hurting legitimate trading. (The average blink of an eye, by the way, takes several hundred milliseconds.)
QUOTE STUFFING ANALYSIS
The following excerpt from the Nanex Report is entitled, “Quote Stuffing, A Manipulative Device”:
While analyzing HFT (High Frequency Trading) quote counts, we were shocked to find cases where one exchange was sending an extremely high number of quotes for one stock in a single second: as high as 5,000 quotes in 1 second! During May 6, there were hundreds of times that a single stock had over 1,000 quotes from one exchange in a single second. Even more disturbing, there doesn’t seem to be any economic justification for this. In many of the cases, the bid/offer is well outside the National Best Bid/Offer (NBBO). We decided to analyze a handful of these cases in detail and graphed the sequential bid/offers to better understand them. What we discovered was a manipulative device with destabilizing effect.
The fingerprints of these quote stuffing sequences are evident when looking at specific and unusual bursts of quote data.. The burst will often occur within a 1/2 second or less time frame and can represent literally thousands of quotes within the burst. As time frames are so short, it is easy to see how these extremely unusual bursts of data may go unnoticed and even when this unusual data is found, it must be looked at graphically to understand exactly how unusual it is.
In the following data sets, every quote listed or charted was received as a “normal,” valid quote (IE quote Condition 0, a valid price and size on both sides of the quote). The one exception is the obvious intermittent “stub” quotes reported by BATS, in which the price will flip from 0.001 to a price near the actual BBO (near being a relative term for BATS) and back again. While the stub quotes actually ARE denoted as a normal quote in the stream, they are in fact the method used by BATS to denote a stub quote.
It is worth emphasizing the following charts represent a mere handful of stocks where this quote stuffing occurred on 5/6/2010. These were randomly chosen from a large list of possibilities and provide a good representation of the phenomena. Quote stuffing is also not a rare occurrence and these sequences are seen frequently on a daily basis; they are easy to find once you know what to look for.
Conclusion:
What benefit could there be to whomever is generating these extremely high quote rates? After thoughtful analysis, we can only think of one. Competition between HFT systems today has reached the point where microseconds matter. Any edge one has to process information faster than a competitor makes all the difference in this game. 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. We think it played an active role in the final drop on 5/6/2010, and urge everyone involved to take a look at what is going on. Our recommendation for a simple 50ms quote expiration rule would eliminate quote-stuffing and level the playing field without impacting legitimate trading.
Added 06/25/2010: It is important to note that we understand 5,000 quotes in one second on any given issue would pose no problem. However, consider that there are approx. 4,000 stocks listed on the NYSE and 9 reporting exchanges. If each reporting exchange for each stock quoted at 5,000 per second this would work out to 180,000,000 quotes per second. Furthermore 5,000 quotes per second is 5 changes per millisecond. At those rates you’d have to abandon the concept of market orders entirely. In fact, at rates exceeding even 50 quotes per second/stock you’d have to abandon market orders entirely. Some would also point out that you couldn’t change the prices at those rates due to the bid/ask spread being so narrow. However there are plenty of cases where the price remains fixed and the sizes flutter.
Furthermore, a CQS quote is 58 or 102 bytes depending if it’s a short or long quote respectively. If the bbo is affected, then add 28 or 58 bytes for a short or long appendage respectively (if the goal is to stuff everyone, you can be sure it would require a long quote and affect the bbo). This equates to a minimum size of (5,000 x 58) 290,000 bytes per second and a maximum size of ((102+58) x 5,000) 800,000 bytes per second for 1 exchange for 1 stock. As a T1 line is 150,000 bytes/sec, one stock ticking away at the minimum 290,000 bytes per second would jam two T1 lines.
Source
From the Nanex Report.
Quote-stuffing among a tiny group of stocks won’t necessarily derail market trading, he says, but on a larger scale it will. “It would completely saturate the consolidated quote system and quotes will get delayed,” he says. “That’s what we saw on May 6.”
Hunsader says half of the quote traffic on May 6 should not have existed. “It was either way outside the market, or didn’t last long enough to make sense for anybody to execute,” he says. His report also recommends that quotes should be time-stamped to reflect when they are created by an exchange, rather than when they are transmitted.
Harris, however, says that while a 50-millisecond rule probably wouldn’t burden legitimate trading strategies, it also probably wouldn’t resolve the problems that caused the flash crash. “The flash crash took place over 5 minutes, not a few seconds,” he says. A simpler fix, he contends, would be to require all orders to be “limit” orders with a specific limit on the price someone is willing to accept.
Other Ideas
Quote stuffing isn’t the only area that might see new SEC rules. In her speech, Schapiro said the entire regulatory scheme that applies to high-frequency trading firms is “an area that warrants close review.”
Schapiro
In the old days of a manual market structure, trading participants with the best access to markets—that is, the specialists who worked on the floor of the dominant exchanges—were obligated both to provide liquidity and promote price continuity, and to refrain from trading in ways that would exacerbate price fluctuations.
Those obligations “have fallen by the wayside as the traditional specialist role became obsolete,” Schapiro said. She hinted that the SEC might want to revive that premise in today’s world of electronic trading; the issue, she said, is whether firms that effectively act as market-makers during normal times “should have any obligation to support the market in reasonable ways in tough times.”
Schapiro said the SEC may reconsider circuit breaker rules it put in place earlier this year to halt trading in individual stocks if the price moves 10 percent or more within five minutes.
“Our next steps are likely to include a careful review of a limit up/limit down procedure that would directly prevent trades outside specified parameters, while allowing trading to continue within those parameters,” she said. “We should work to develop an improved circuit breaker mechanism that secures the advantages of both limit up/limit down and trading pauses.”
Schapiro also said larger circuit-breakers that halt all trading in securities when the Dow swings more than 10 percent should also be reviewed, even though those limits weren’t hit in the May 6 flash crash.
No comments yet