BATS trading errors highlight perils of technology arms race
US exchange operator BATS Global Markets’ revelation earlier this week that it may have accidentally breached best execution regulation on thousands of client transactions over a four-year period has been criticised by senior buy-side traders, who have expressed disappointment at the failure of exchanges to serve long-term investors.
“The BATS issue just sums up the problems with the arms race to technology that has caused so many problems for traditional investors,” Adrian Fitzpatrick, head of investment dealing at Kames Capital, told Banking Technology. “If I wanted to play Xbox all day I would stay at home. Regulators need to realise what the market is for and from my perspective it should be for institutions not HFT.”
In recent years, exchanges have suffered a series of high-profile technology problems that have led many market observers to conclude that excessive focus on speed at the expense of stability has undermined the stability of equity markets. The London Stock Exchange experienced a series of crashes, including an incident where trading was halted for four hours, when it migrated to its new MillenniumIT trading engine in February 2011. In March 2012, BATS was forced to cancel its own IPO after a trading glitch caused shares to collapse to less than a cent in value in seconds. Then in May 2012, Nasdaq suffered an embarrassing trading malfunction during the IPO of Facebook, which left investors unable to see whether their transactions had gone ahead. In January, Nasdaq suffered a further glitch on its market data feed that upset trading on its US market.
Exchanges around the world, including Brazil’s BM&F Bovespa and Japan’s Tokyo Stock Exchange, have been keen to reduce latency and trim down their platforms to attract HFT firms because HFT boosts trading volumes, leading to greater profits. HFTs typically transact thousands of small orders per second, arbitraging tiny price differences that may exist for only a fraction of a second. But the cost to long-term investors has been severe, according to several different studies and many buy-side market participants.
In April last year, Brussels-based public interest body Finance Watch produced a paper entitled ‘Investing not betting’, in which it argued that HFTs are hurting the real economy by stealing money from longer-term investors. Earlier research by CA Cheuvreux has also indicated that HFTs generate huge amounts of market “noise” that makes it difficult for buy-side firms to discern genuine liquidity.
“This is a big bugbear for the buy-side, and it is not improving,” added Fitzpatrick.
Other market observers, including Tony Mackay, founder of alternative trading system Chi-X, have agreed that a “race for speed” has resulted in an equity market full of “fast but dumb” matching engines that do not serve the needs of buy-side investors, who typically want to trade in larger blocks but are unable to do so for fear of being gamed by aggressive high-frequency traders. Mackay is currently working on developing a new trading venue, which he says will use social networking principles to let users decide which ‘friendly’ counterparties they are willing to interact with, and which to avoid.
In Europe, there have been some moves to counteract the effect of HFT. Italy’s Borsa Italiana introduced a scheme last April that charges HFTs that exceed an order-to-cancel ratio of 1:100. The aim is to cut down on the amount of ‘noise’ they generate by making it more expensive to cancel too many orders. In France, the introduction of a unilateral financial transaction tax has made it less profitable for HFTs to enter and exit the market based on tiny price differences; senior politicians including the country’s finance minister have also called for an outright ban on HFT.
However, not everyone agrees that regulators should re-adjust the market to penalise HFTs and favour long-term investors. Frederic Ponzo, managing partner at capital markets consultancy GreySpark Partners, argues that while exchanges have cut corners to provide for HFTs at the expense of the longer-term investor, a competitive market structure is still best because it provides opportunities for new companies to come in and fill the gap left by under-served investors.
“I don’t agree that markets are just for long-term investors,” he said. “Markets are for everyone – retail investors, banks, companies floating shares, and even speculators. All fulfil a useful function in the market. It’s like saying flying is for business class passengers only. I want to fly too.”
Citing Eos Airlines, which ran a business-class only airline service in the mid-2000s, Ponzo suggested that HFT was the equivalent of the economy class passenger who might not drink the complimentary champagne, but was still legitimately entitled to use the service. The lesson for equity markets, he added, was that specialisation of trading venues, some towards the high-end long-term investor and some towards the HFT, was a better solution than a monopolistic market structure.
“Different venues have different roles,” he said. “For example, BATS is the cheapest – it’s the Ryanair of trading. It gets you from A to B cheaply, and that is a useful service. In response, exchanges like the LSE have cut costs to pursue that ‘economy class’ HFT part of the market. But some customers want to fly business class, and those customers are moving to other venues that provide a more high-end service. There is nothing wrong with that.”