The impact of high-frequency trading (HFT) on market integrity has become a hot issue as of late, particularly in the U.S. but also in Canada. Allegations of manipulative and predatory behaviour by some high-frequency traders (HFTs) include electronic front-running (using advanced software and fast access to front-run trades) and rebate arbitrage (taking advantage of the rebates offered through the “maker-taker” model). The result for investors, according to Michael Lewis in Flash Boys: A Wall Street Revolt, is that the markets are rigged and the deck is stacked against them.
There are many developments that have led to the current system and opportunities for manipulative, deceptive HFT activity. These include advancements in technology, market fragmentation and the demutualization of stock exchanges. Although computers have been used in trading for some time, the use of complex algorithms and automated systems to initiate trading activity is a relatively new phenomenon —one that far outpaces regulatory efforts to oversee such activity. HFTs are not the first to engage in manipulative activity such as front-running but the speed and complexity of their trading activity makes such activity much more difficult to detect and guard against.
Securities exchanges play a vital role in capital formation. They’re essential market intermediaries, bringing together the providers and users of capital to facilitate the optimal allocation of financial resources. However, it’s important, to recognize that although securities exchanges are charged with an essential public function, they also are for-profit entities that exist to maximize profits for their shareholders.
Exchanges and alternative trading systems (ATSs) earn revenue from a variety of sources, including listings fees, trading fees and technology services such as co-location and proprietary data feeds. Exchanges and ATSs now rely on revenue from HFT, which causes them to favour the interests of HFTs — including those who are looking for a trading advantage — over the interests of more pedestrian market participants.
The Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) is concerned that this reliance and resulting favouritism gives rise to several market structure, integrity and fairness issues — and likely will erode public confidence in securities markets. These are issues regulators must address.
At the core, market quality, efficiency, and integrity must be maintained. Markets must be fair and, just as important, must be seen to be fair. Regulators could improve market fairness in several ways.
For example, they could — and should — prohibit exchanges and ATSs from providing trading advantages to sophisticated market participants who generate very large volumes of orders and trades (and therefore significant profits and market share) over individual investors and other participants who do not generate significant levels of activity. One way of doing so might be to charge fees for orders, including any change or cancellation. Such a charge could reduce the profitability of entering orders designed merely to extract information.
In addition, time delays of even a fraction of a second could address issues such as electronic front running. And the rebates provided through the “maker-taker” model should be examined to determine their impact on market integrity, as they may result in the unintended effect of rewarding HFT for trading that is of no benefit to the market. In order to prevent extreme events such as flash crashes, regulators could also require testing of algorithms prior to launch in live trading.
Furthermore, regulators should take enforcement action against manipulative and deceptive trading practices, including front running by HFTs. FAIR Canada understands that such enforcement action is currently underway in the U.S., and it encourages regulators here in Canada to send a clear message that manipulative and deceptive trading activity will result in severe sanctions.
Canadian regulators are in the process of analyzing HFT and its impact on the market. FAIR Canada supports this initiative. However, it’s essential that regulators move quickly to ensure exchanges and ATSs operate in a manner that all investors — regardless of their size or speed — can utilize with utmost confidence.
With contributions from Lindsay Speed, legal counsel and corporate secretary at the Canadian Foundation for Advancement of Investor Rights