TABLE OF CONTENTS I. INTRODUCTION 1360 II. DEFINITIONS: WHAT EXACTLY IS HFT? 1362 A. Key Characteristics of HFT 1363 B. HFT Strategies 1364 C. Traders and Types of Securities Traded 1367 III. PROMINENCE: HOW DOES HFT IMPACT MARKETS? 1368 A. Benefits of HFT 1368 B. Costs of HFT 1370 1. Competitive Advantage 1370 2. Model Risk 1372 3. Macroeconomics 1373 IV. REGULATION: HOW CAN REGULATORS CONTROL HFT?. 1374 A. Purpose of Regulation 1374 1. Competition in the Market 1374 2. The Efficient Capital Markets Hypothesis 1375 B. Efforts in the United States 1377 1. The SEC and Regulation Systems Compliance and Integrity 1378 2. The SEC, FINRA, and Enforcement 1380 3. The CFTC and "Spoofing" 1381 4. The CFTC and Regulation Automated Trading 1384 C. Efforts in the European Union 1388 1. MiFID II 1388 2. Reactions to MiFID II 1390 V. POLICY CONCLUSION: HOW SHOULD REGULATORS CONTROL HFT? 1392 I. INTRODUCTION
"People no longer are responsible for what happens in the market, because computers make all the decisions." (1) High frequency trading (HFT) is a phenomenon some perceive as the next imminent failure of modern markets. To critics like Michael Lewis, author of Flash Boys: A Wall Street Revolt, HFT is a scheme by which computer whizzes can program computers with algorithms to cheat more traditional investors out of an honest day's work. (2) While dramatized, his depiction captures the heart of critics' argument that HFT should be regulated because it represents the worst of technological innovation and human nature combined.
Yet others perceive HFT as a market-moving mechanism that benefits the exchange of securities and derivatives and a natural progression of market competition. In Flash Boys: Not So Fast, former Goldman Sachs trader Peter Kovac critiqued Lewis's attacks on HFT and the related call for regulation, denouncing the alleged "cheat" aspect of HFT and possibly fully discrediting the existence of HFT. (3)
If nothing else, this feud demonstrates that HFT is on the public's mind, and certainly not for the first time. Starting as far back as the "Black Monday Crash" of October 19, 1987, when the stock market took its steepest ever single-day dive, many saw such stark volatility as a failure of market makers, which HFT traders are now considered. (4) More recently, the 2008 Financial Crisis instilled a renewed aversion to risk and set the stage for the rise of HFT, since HFT is a seemingly low risk operation. The May 2010 "Flash Crash" highlighted HFT's effect on computer-driven markets as "far more dangerous than anyone had realized," (5) even though markets quickly rebounded to recover all losses that same day. (6)
As HFT traders have gained further influence in the markets, regulatory efforts have multiplied in the interest of leveling the playing field between more traditional algorithmic trading and HFT. In particular, regulators are concerned that the speed at which HFT traders operate could marginalize traditional traders and potentially destabilize markets. (7) Attempts to address such concerns include the U.S. Securities & Exchange Commission's (SEC) proposed Regulation System Compliance and Integrity (Reg SCI) in 2014 and, more recently, the U.S. Commodity Futures Trading Commission's (CFTC) proposed Regulation Automated Trading (Reg AT). (8) Moreover, a new US stock exchange, Investors Exchange (IEX), recently began operations on the premise of heightening efficiency and fairness among traders. (9)
While US regulatory efforts have seen mixed results, in April 2016 the European Union implemented a plan for the Markets in Financial Instruments Directive II (MiFID II). Fully effective in 2018, MiFID II represents the European Union's first attempt to regulate HFT and could be a step in a long line of future regulations. (10) Like the United States, the European Union has seen HFT account for an increasing proportion of trading, but as of yet European HFT traders have escaped the level of oversight applied to other traders (i.e., brokers). (11)
But what exactly is HFT, and how can it be regulated without completely smothering market competition? This Note addresses the debate across the United States and the European Union on HFT as a practice. Part II compares efforts to reach a holistic definition of HFT and its common strategies in the United States and the European Union. Part III evaluates HFT in terms of its prominence in and impact on markets in the United States and the European Union. Part IV compares US and EU approaches to regulate HFT, particularly the US Reg SCI and Reg AT and the EU MiFID II. Part V evaluates the approaches discussed in Part IV in light of regulators' concerns and the individualized needs of the United States and the European Union.
DEFINITIONS: WHAT EXACTLY IS HFT?
The debate over how to regulate HFT originates in its definition. To fully understand HFT, one must first distinguish it from larger umbrellas of trading, such as algorithmic trading. Algorithmic trading usually refers to fund managers' use of trading strategies to exchange large volumes of assets at minimized cost under preset limits of risk and time. (12) The crux of algorithmic trading lies in these preset rules on how to execute each trade order; the goal is to secure a good price relative to specified benchmarks and to minimize the impact of trading by actively responding to events in the market. (13)
HFT, which refers to complete automation of the quantitative trading process, forms a subset of algorithmic trading. (14) HFT narrows the scope of algorithmic trading because it uses computer-automated algorithms to execute trades without human influence. (15) Such computer automation hinges on quantitative modeling and indicator tracking to determine when and how to execute trades, taking traders' activism out of the equation except in the event of "flash crashes." Hedge funds typically implement algorithmic trading to execute trades and monitor portfolio risk, and HFT can be used to incorporate this information into pricing and trading decisions. (16)
Most agree that the hallmark of HFT is its transience; HFT traders seek and act on opportunities in a matter of milliseconds (thousandths of a second). (17) While many brokers and dealers offer solely algorithmic trading, algorithmic trading is less anticipatory, less high-frequency, and less high-tech than HFT. Beyond the time frame, however, characterization of HFT is hazy. From types of securities traded to specific trading strategies, authorities across the United States and the European Union lack uniformity in their descriptions.
Key Characteristics of HFT
Recent US and EU attempts to outline the key characteristics of HFT share a lack of commitment to a set of uniform features. The SEC has named non-defining but important criteria for HFT in the United States. (18)
Along with short time frames and the use of algorithms, the SEC highlights the location of computer servers close to trade exchanges, a phenomenon known as co-location. (19) The amount of time taken to execute a trade, down to the millisecond, can greatly affect who gets to trade on that particular opportunity. So, the greater the physical distance from the server to the actual exchange (i.e., New York Stock Exchange [NYSE]), the longer it takes for the computer signal to travel round trip to execute the trade. (20) As a result, a new sideline market has arisen in which HFT competitors pay millions of dollars for the right to place their servers in the same room as the exchange hub to eke out an edge of mere milliseconds. (21) Such competition also breeds from the algorithms used by each HFT trader, so in reserving the coveted floor space in the exchanges, HFT traders cautiously physically cover their servers such that no information will leak to the competition. (22)
The SEC also characterizes HFT as using small amounts of daily capital to make a tiny gain per individual transaction. HFT traders generate money by trading for small increments of time and making incremental but steady profits on each individual trade. (23) Because of the high speed at which HFT traders execute trades, they process a high volume of transactions per day and thus turn a significant profit. Furthermore, HFT traders cancel over 90 percent of their orders before they are executed (see the "order anticipation" HFT strategy discussed in Part II.B). (24) This creates the perception that HFT is a low-risk operation, as several HFT firms can boast minimal losses over years of trading. (25)
While the characteristics and behaviors the SEC specifies are not limited to HFT, they outline the baseline view of HFT in the United States--fast, profitable, and competitive, for better or for worse.
The International Organization of Securities Commissions (IOSCO) characterizes HFT not as a single strategy but as a "set of technological arrangements and tools employed in a wide number of strategies, each one having a different market impact and hence raising different regulatory issues." (26) The three most prominent strategies of HFT--order anticipation, market making, and arbitrage--rely heavily on the speed at which HFT operates.
The order anticipation HFT strategy arguably receives the most attention of the three prominent strategies because some see it as the driver of unfairness behind HFT. (27) As a directional strategy, order anticipation involves parsing out whether a major investor has placed a large order such that an HFT trader can use its advantageous speed to trade ahead of that investor. (28) To outmaneuver the major investor, HFT traders engage in "pinging." That is, HFT traders use pattern algorithms to send out "feeler-orders" to find potential larger orders and determine how large traders may behave. (29) Because HFT traders can submit high volumes of these feeler-orders quickly, they can capitalize on opportune orders ahead of traditional investors. (30) The feeler-orders are usually cancelled; as mentioned...