SEC chairman Mary Jo White spoke on Thursday about high frequency trading. She made clear that she not going to do much to curb it but will engage in more studies so as to look to be Doing Something.
One of the things that is particularly troubling is White’s effort to finesse that she’s abandoning one of the foundations of securities laws in the United States, The Securities Exchange Act of 1934. John Hempton, who was a member of Australia’s Treasury, calls the 1934 Act one of the best pieces of legislation ever written.
Notably, the first section of her speech is “Taking Principled Action” (Orwell alert). And she discusses high frequency trading in term of what she sees as critical criteria, such as fairness, market structure, but only in terms so vague as to be obfuscatory:
First, we must evaluate all issues through the prism of the best interest of investors and the facilitation of capital formation for public companies. The secondary markets exist for investors and public companies, and their interests must be paramount.
Second, we must account for the varying nature of companies and products, with a particular sensitivity to the needs of smaller companies. One market structure does not fit all.
Third, our review of market structure must be comprehensive. We must test our assumptions about long-standing rules and market practices. Past decisions must be reevaluated in light of current conditions, and market-based solutions to issues should be explored. Barriers to such solutions must be reviewed, and removed where appropriate.
Why is this troubling The US is a rules based system, not a principles-based system. Perversely, while financiers make an art form of regulatory arbitrage, as in finding an artful path through regulations to do things that might not pass the smell test, here White is reverting to principles, not to update the implementation of the foundational securities laws, but to justify market activities she deems to be generally benign (or alternatively, has no stomach to combat). There’s no reference in the entire speech to the 34 Act, which created the SEC, nor to its key principles, such as “no front running”.
Even more so than Tim Geithner in a March 2007 speech which we found troubling at the time, White treats financial innovation, in this case, high frequency trading (which she repeatedly and misleading conflates with alogrothmic trading, when many algos aren’t high frequency traders) as a fact of life. This is another manifestation of what Lambert has called “code as law”, the tendency of regulators and the courts to make rules and regulations adapt to “innovations,” rather than take the posture that the “innovation” is not allowed to go live unless it fits within existing legal parameters or gets the needed approvals first.
White also goes to some length to depict the impact of high frequency trading as positive, such as in terms of lower transaction costs. But as analysts and economists are increasingly pointing out, beyond a certain point (and we seem to be well past there in equity markets), more liquidity is not beneficial. So her “cheaper trading is better” premise which pervades the speech is subject to question (and that’s before the fact that it isn’t obvious how much of that can be attributed to high frequency trading). Indeed, studies have repeatedly found that overtrading diminishes returns. Cheap trading makes it seem low cost to act on impulse; higher trading costs would lead to more deliberation.
There is also the not-trivial matter of the SEC’s culpability for allowing high frequency trading to flourish. The agency allowed co-location of servers and payment for order flow. two dubious practices that critically important to the operation of high frequency traders. White is new to the agency. White didn’t have to defend the policies and inaction of her predecessors, but she’s clearly falling in line with the status quo. For instance, White stated:
All of these market quality metrics show that the current market structure is not fundamentally broken, let alone rigged. To the contrary, the equity markets are strong and generally continue to serve well the interests of both retail and institutional investors.
That’s an obvious rejection of Michael Lewis’ claim.*
Finally, White bizarrely makes only the most oblique references possible to the flash crash and insists market structure is fine. She looks to comparisons of various averages over time, like order execution costs in light of average volatility measures.
The problem with that is it completely misses the issue of robustness. The old market structure, which she sniffingly depicts as “manual” had specialists who were obligated to make markets. As quite a few academics have pointed out, with compelling analysis to support their views, high frequency trading provides junk liquidity: abundant liquidity when you don’t need it, when markets are functioning normally, and liquidity drainage when markets are volatile (White did not discuss how high frequency impacts roiled markets).
Now that isn’t to say that White said she’d do nothing in her speech, but she clearly does not intend to do much. The most important concrete step is high frequency traders should be required to register as broker-dealers. The SEC will also require more disclosures (more on that shortly). But she’s mainly going to get more data and study the issue more. This is not encouraging. First, this looks to be a cynical move to push the time frame for any further action so as to allow the Flash Boys-induced furor to die down completely. Second, as any student of financial regulatory non-reform will tell you, studies allow the industry oodles of time to lobby, both to try to influence the study design, then to argue with findings, then to argue with proposals based on the findings. That’s why Dodd Frank authorized so many studies, to make sure the reforms were diluted.
Even Matt Levine, who is notably Wall Street friendly, made it clear that it was obvious what White is up to.He discussed at length what you’d do if you were concerned about high frequency trading, which is act like Eric Schneiderman**:
New York Attorney General Eric Schneiderman, for instance, pretty clearly believes that high-frequency trading is Bad. He thinks the whole thing is “Insider Trading 2.0.” So his goal seems to be to eradicate it entirely, by going after direct feeds from exchanges and co-location and even just the continuous trading of stocks.5 In Schneiderman’s ideal world, speed would simply be eliminated as a trading advantage.
That is not Mary Jo White’s world, and it shows in her proposals for improving the markets. If you think that the current HFT business model is basically good for the world, then you will be hesitant to make fundamental changes to it. And if you’re the SEC, and you’re under a lot of Michael-Lewis-driven pressure to make fundamental changes to market structure, what do you do?
Disclosure. You do disclosure. To be fair, disclosure is the SEC’s answer to most questions, but it’s especially the answer to questions that the SEC doesn’t especially want to talk about.
So, for instance, one concern that investors have is that high-frequency traders use faster direct feeds from exchanges to pick off investors who rely on the slower, official consolidated data feed.6 One way to resolve this would be to ban speedy direct feeds, which is more or less what Eric Schneiderman wants.7 Here’s Mary Jo White’s approach:
I am also asking the exchanges and FINRA to consider including a time stamp in the consolidated data feeds that indicates when a trading venue, for example, processed the display of an order or execution of a trade. With this information, users of the consolidated feeds would be able to better monitor the latency of those feeds and assess whether such feeds meet their trading and other requirements.
And I am asking the exchanges to develop proposed rule changes to disclose how — and for what purpose — they are using data feeds. For example, which data feeds are used to execute and route orders? And which feeds are used to comply with regulatory requirements, such as trade-through rules? Brokers and investors could use the enhanced transparency to better assess the quality of an exchange’s execution and routing services.
So exchanges can still use slower feeds to price trades while selling faster feeds to HFT firms. They just have to tell tell investors what they’re doing, so the investors can judge for themselves if they’re getting ripped off.
Do you worry that brokers are acting against their customers’ interests in order to take advantage of exchanges’ maker-taker fees and rebates? Maybe you could ban those fees and rebates. Or not. You could just tell people more about them:
I have asked the staff to prepare a recommendation to the Commission for a rule that would enhance order routing disclosures. Rule 606 of Regulation NMS currently requires some public disclosure of broker order routing practices, but it does not cover the large orders typically used by institutional investors. The rule proposal would address this gap by requiring disclosure of the customer-specific information that a broker is expected to provide to each institutional customer on request.
Are you suspicious of dark pools?
Just this week, FINRA began disseminating aggregate information on trading volume of ATSs. This is a useful first step, but ATSs represent less than half of dark venue volume. To remedy this gap, I fully support FINRA in considering an expansion of its trading volume disclosure regime to off-exchange market makers and other broker-dealers.
I also have asked the SEC staff to prepare a recommendation to the Commission to expand the information about ATS operations submitted to us and to make the information available to the public. As you have seen in the recent media, some operators of dark venues began offering greater transparency to their operations this week, but a broader effort is needed.
You get the idea. The SEC’s core view is that the fundamental business model of high frequency trading is fine. There are probably some abuses at the margins, and shedding some light on those margins will be enough to correct those abuses. But for the most part, White thinks, our market structure is nothing to be embarrassed about, so there’s no reason to fear broader disclosure.
Yves again. Levine, in a key footnote, also explains why White’s cheery patter about apparent order execution costs (based on bid-asked spreads and commissions) misses a critical point:
I mean, for instance, “Flash Boys” itself quotes a lot of money managers complaining about high frequency trading. They at least perceive that they’re getting ripped off, and there are some studies that support this view.
It’s worth spending a minute to understand why this question doesn’t have an obvious answer. When you buy 100 shares of a liquid stock, you pay a $10 commission and buy at (or below) the displayed inside offer. When you buy 10,000 shares, though, you probably don’t get all of those shares at the displayed offer. Maybe you get 1,000 at the offer, and then all of a sudden all the displayed bids and offers move up, and you end up paying an extra 10 cents for the other 9,900 shares. Here some obvious first-order measures of trading cost (bid/offer spread) suggest that your costs are low, but the fact that the market moves so quickly makes your actual cost high. But, of course: If the market makers couldn’t move so quickly, they’d have displayed a wider quote to begin with. So it’s hard to know whether you’re ahead or behind, on net.
In other words, the sort of analysis White invokes appears to miss completely the price change issue. Now perhaps her Penelope 2.0*** studies will get at that, but I wonder how one could even construct good proxies, let alone ones that will stand up to industry efforts to pull them apart.
White is thus playing true to a pattern all too familiar among financial regulators: make sufficient noise about a problem so as to appear to be doing something, but take a generally Panglossian view of the current system and focus only on a few undeniable warts to as to appease critics. Whether this stance is the result of intellectual capture, soft corruption, lack of courage, or lack of imagination is moot. The industry-accommodating results are pretty much the same.
* On this point, I agree with Felix Salmon: Lewis is all wet as far as retail stock traders are concerned.
** Sadly, as much as Schneiderman typically comes out on the right side of issues, he’s all hat, no cattle, in terms of doing anything about them.
*** As in the delaying tactics of Odysseus’ wife.