Trust and the Markets: A Debate on High-Frequency Trading

Historical Drivers of HFT:

• Decimalization (late 1990s): Narrowed quoted spreads (e.g., from 20-2025 to 20-2001), encouraging algorithmic trading and faster automated matching.
• Reg NMS (implemented 2007): Introduced competing trading venues and dark pools, sparking an "arms race" for speed and automation.
• Peak Profitability: High-frequency trading (HFT) volume and profitability peaked between 2009 and 2012.
• Recent Margins: Competition has compressed margins; 2013 HFT profits were estimated at $1.1 billion, representing less than 0.1% of total trade face value.

Definitions and Taxonomy of HFT:

• Jim McCoggin's Definition: Characterized by rapid-fire execution, massive order volumes, and high cancellation rates (testing the market) to add value via speed.
• Rishi Narang's Correction: Emphasizes "low-latency sensitivity" over mere speed; defines HFT by how quickly one can access markets and assess data to identify opportunities.
• Three Categories:
  • Market Makers: Provide liquidity via passive orders on lit exchanges or internalize flow from brokers.
  • Arbitrageurs: Capitalize on pricing inefficiencies between fungible instruments in different venues (e.g., IndexARb).
  • Fast Alpha: Execute timing decisions (buy/sell) faster than the average investor but hold positions longer than pure HFT.

Speed and Market Impact:

• Intraday vs. Overnight Volatility: Intraday volatility remains largely unchanged since the advent of HFT, while overnight volatility has increased by 41%, driven by macro news rather than HFT activity.
• Flash Crashes: There have not been more "flash crashes" since HFT; incidents in 1962 and 2010 are comparable in nature, suggesting no causal link to volume.
• Order Cancellation: Average order resting time is 2–3 seconds; however, high-frequency cancellations at microsecond levels incur socialized costs on exchanges and other investors.

Controversies and Ethical Concerns:

• Front-Running Accusations: McCoggin alleges that some HFTs exploit fragmented markets to trade ahead of large investor orders, leveraging information leakage to their detriment; Narang counters that reacting to public tape data is fair, noting a 20-minute delay for retail investors is not considered front-running.
• Payment for Order Flow (PFOF): McCoggin argues PFOF creates an intolerable conflict of interest; Narang views it as ambiguous, noting it has helped lower retail commissions but adds complexity.
• Regulation Consensus: Both agree that current market conduct rules (specifically Reg NMS) have not kept pace with technology; both support the elimination of the "ban on locked markets" to reduce order type complexity.

Dark Pools and Transparency:

• McCoggin's Stance: Opposes dark pools and internalization, arguing all trading should occur on lit exchanges to ensure transparency and fiduciary duty; views PFOF and make/taker practices as requiring regulatory outlawing.
• Narang's Stance: Supports dark pools as heterogeneous tools for institutions to protect intellectual property (order flow); argues the issue is not existence but lack of transparency regarding who can see orders and when.
• Investor Perception: A London academic poll cited by McCoggin shows investor distrust of HFT rivals only that of insider trading.

Regulatory and Legal Outlook:

• Pending Litigation: Multiple lawsuits (e.g., Providence v. Bank of America) target approximately 20–40 firms; outcomes are expected to clarify the prevalence of "bad actors" vs. legitimate market activity.
• Proposed Reforms:
  • Equalize data feed speeds (make the SIP as fast as direct feeds) to ensure a level playing field.
  • Penalize excessive order cancellations via exchange-level messaging charges.
  • Potentially ban PFOF to simplify market structure.
• IEX as a Test Case: Narang notes his firm trades on IEX (technically a dark pool) as a model for a cleaner marketplace, though its long-term success remains unproven.

Forward-Looking Statements:

• Market Evolution: The industry is unlikely to reverse HFT due to its 50%+ share of equity volume; the focus must shift to regulatory frameworks that address speed and conduct rather than banning speed itself.
• Regulatory Necessity: Both panelists agree that market-based solutions alone are insufficient; SEC intervention and new market conduct rules are required to align technology with fair practice.