Regulators And Traders Fail To Keep Pace In High Frequency Markets

February 8, 2013

Can humans keep pace against high frequency trading?

How nice that the good folks at the Department of Justice are getting around to charging the good folks at McGraw-Hill and Standard & Poor's for that untidy mess involving all those years of ratings.  Not that anyone in regulation ever had even so much as an inkling that the whole rating biz was just a tad conflicted when all those uppercase letters and minus and plus signs were being awarded.

Course not.

I mean, c'mon, you remember how it was: Folks were making the big bucks hand over fist and it was all so euphoric and wonderful and we had money to burn and all those houses to buy and all those inflated incomes and bogus assets.  Why go looking for troubles in the halcyon days?

Me?  I ain't shedding a single tear for any rating agency. Don't like ‘em. Never trusted ‘em.

On the other hand, there's something awfully sanctimonious about market regulators climbing onto this finger-pointing bandwagon, now that it's in the ditch, its wheels are broken, and the freight is smashed to smithereens. The whole public hoopla smacks more of a CYA autopsy than meaningful, preventative regulation.

I mean, you know, just what the hell was it that caused the Flash Crash? What caused that market freeze with Knight, and that  Facebook/NASDAQ crash and burn, and that other mess with the BATS IPO?  Who did what, when, and to whom? Yeah, okay, I know, all of you regulators are working on that. You"re getting to it. But where the hell were y'all when the red flags were waving and the warning flares were lighting up the skies? You know what I'm sayin' - like, for example, when the Street was pushing all that toxic mortgage paper with the AAA+++ ratings.

According to the press, the Securities and Exchange Commission is talking dollars - some reports suggest $5 million in fines - with the NASDAQ OMX Group as part of the federal regulator's possible resolution of the May 18, 2012, debacle that was the launch of the Facebook IPO.  Although $5 million may seem like a lot of bucks, keep in mind that as recently as September 2012, NASDAQ offered a $62 million restitution package to industry participants harmed by the snafu, but that offer's reception was, at best, lukewarm.  Purportedly, that disastrous attempt to take the social media firm public was hampered by technical glitches at NASDAQ, resulting in at least $500 million in losses for many market makers and broker dealers. Not the least of the damages was the significant black eye sustained by the NASDAQ operator.

Of course, while the little pieces of paper with dollar signs are furiously passing back and forth between the SEC and NASDAQ, one has to wonder just what's going on with that similar mess involving Knight Capital. As Street Sweeper discussed in "SEC Schapiro's Opening Salvo At Knight Capital's Apparent Trading Error" (August 6, 2012), on August 3, 2012, then SEC ChairMary Schapiro issued a statement on the trading issues that had involved Knight Capital Group.  Her comments were published in an SEC press release: Chairman Schapiro Statement on Knight Capital Group Trading Issue (#2012-151, August 3, 2012).  Among Schapiro's comments were:

The apparent trading error by Knight Capital Group on Wednesday reflects the type of event that can raise concerns for investors about our nation's equity markets - markets that I believe are the most resilient, efficient, and robust in the world. . .

Reliance on computers is a fact of life not only in markets everywhere, but in virtually every facet of business. That doesn't mean we should not endeavor to reduce the likelihood of technology errors and limit their impact when they occur. . .

In addition, existing rules make it clear that when broker-dealers with access to our markets use computers to trade, trade fast, or trade frequently, they must check those systems to ensure they are operating properly. And, naturally, we will consider whether such compliance measures were followed in this case.

If timing in life is everything, on Wall Street it's more than everything. Fortunes are made and lost these days in fractions of a second, the blink of a computer's eye. Some say that the markets have become slavish captives to high-frequency trading - that we've lost our ability to keep pace and we are unable to effectively regulate. Others simply say the more the merrier and if you can't keep up, get off the track.

You think that I'm exaggerating about how fast things move on Wall Street?  You think that I overstate the problem when I often complain that our regulators are falling behind in their attempts to merely catch up?  How about this for a point: As of today, February 8, 2013, Mary Schapiro's August 2012 comments about Knight are now those of not just a former SEC Chair but soon those of the third SEC Chair within a span of less than six months: Schapiro, Walter, and the just nominated Mary Jo White. That a fast enough changing of the guard for you? You think we can effectively regulate the markets with that type of turnover?

I recently sat down on Side Bar With Bill Singer with Forbes' "What Moves Markets" columnist  Shah Gilani to discuss some of the ramifications of high frequency trading and the future role of human beings versus machines in our markets. Gilani is also the editor of Capital Wave Forecast and Spin Trader newsletters, and the author of the Wall Street Insights & Indictments e-letter.

Gilani was an economics major at UCLA in the late '70s and in 1982 found himself on the rough and tumble floor of the Chicago Board of Options Exchange, running a small hedge fund and learning lessons that, frankly, are hard to learn these days - after all, the flying elbows and scowls have largely been replaced by the hidden purring of computer servers and the cold calculations of algorithms  Still, some of us, the old guard, the dinosaurs, the scarred warhorses, remember how things were and, if you allow us some conceit, we still think we can take on the machines - up to a point.

A guy like Gilani was making markets at the old Chicago Board of Options Exchange in the OEX, the original S&P 100 index, on the first day it traded.  And he and his early compatriots came upon the trick of using the OEX options premiums as a rough way to figure out where the market might be headed. Yes, that was how market-makers on the Floor first tried to approximate "volatility," and as a result of the trial and error of Gilani and those traders a generation ago, we now have the VIX.

From the pit, Gilani wound up running the futures and options division of the Treasury for Lloyd's Bank, one of Britain's largest banks.  It was the mid-80's and he was tasked with trying to hedge positions for the government bond trading desk, the currency trading desk and the OTC derivatives desk. If you're too young to remember, it was a time before every office had a computer. You probably have more computing power on your smartphone than was available at most brokerage firms in those days. Guys like Gilani sweated the details and still used pen, pencil, graph paper, and old-fashioned calculators.

From Lloyds, Gilani wound up at the venerable Roosevelt & Cross, a New York City firm started by Teddy Roosevelt's son, where the former Chicago trader set up a packaged products trading desk at a firm where the go-to trades were in Ginnie Mae funds unit investment trusts. Tiring of the Big Apple, Gilani moved to Florida in 1999 and started another hedge fund and opened a brokerage firm focused on direct access trading of what would soon morph into high frequency algorithms, many of which he designed and still uses.

When Gilani and I sat down a few weeks ago to discuss the current state of the markets, it was an interesting back and forth about the inroads of high frequency trading and algorithms.  Paramount was the question of whether there was still room on the floors, in the pits, and at the trading screens for human beings.  You can watch the interview on Side Bar With Bill Singer and see what you think. It's two old warhorses, Wall Street veterans, grousing and crossing swords.

Watch on Reuters Insider the pilot episodes of "SIDE BAR WITH BILL SINGER." Veteran Wall Street regulatory lawyer Bill Singer hosts three episodes of this new program.


The Brave And Scary New World of HFT
Featuring Shah Gilani

The SEC's New Bounty Program For Whistleblowers
Featuring Aegis Frumento, Esq.

Is the U.S. the Only Sheriff in Town?
Dodd Frank And the CFTC's New Swap Regulations
Featuring Professor Ronald Filler, Esq.