Regulators study HOT to try to unravel HFT

Much like the drug testers who finally may be catching up with the doctors and pharmacologists in the sports world, securities regulators now are starting to gain a better understanding of HFT.

In mid-December, the Investment Industry Regulatory Organization of Canada (IIROC) published the first two parts of its long-awaited, three-part study into HFT in Canada. These sections of the study aim to identify just who is into HFT and what their trading activity looks like. In the next phase, IIROC will try to drill into HFT’s impact on the market; this part of the study is expected to be carried out later this year.

Hopefully, at that point, IIROC will be in a position to answer the fundamental question of whether HFT hurts or helps markets.

Proponents of HFT claim that it adds liquidity, thereby reducing spreads and improving market efficiency. However, critics contend that HFT liquidity isn’t real – that it evaporates when markets get volatile and really is available only when it isn’t needed. Moreover, critics charge that HFT: takes advantage of ordinary investors; generates costly, confusing message traffic; and makes markets more fragile – ultimately harming investor confidence.

There is an underlying sense that some HFT strategies are abusive – and possibly even criminal, in certain cases. In fact, IIROC issued proposed new guidance on manipulative trading strategies in the middle of last year, pointing to its study on HFT as an anticipated source of insight into “novel forms of manipulative and deceptive activity.”

In response to that draft guidance, the Royal Canadian Mounted Police submitted a letter in which the force indicates that it’s considering whether various provisions of the Criminal Code could be applied to HFT.

Yet, the issue is highly complex, and there are few definitive answers at this point. As the IIROC study notes, there’s not even a generally accepted definition of what constitutes HFT. The hope is the IIROC study will supply regulators and the market with some definitive conclusions on the effects of HFT once the third phase is complete.

For now, merely identifying the HFT that’s taking place is challenging enough. The IIROC study doesn’t try to define HFT specifically. Rather, it focuses on the activities of traders that would seem to be engaging in some form of HFT, based on the fact that they generate a high number of orders compared with the number of trades they actually complete.

Although this approach doesn’t necessarily capture all the trading activity that could be considered HFT – and it may include some non-HFT trading activity – IIROC notes in its paper that focusing on the order/trade ratio “is most relevant to a number of industry concerns.”

In particular, there are concerns that: this sort of activity is inflating costs for marketplaces, dealers and regulators that must process and store vast quantities of data; this sort of trading represents “phantom” liquidity; and creating worry among regulators about high order rates affecting market quality and integrity.

IIROC’s research focuses on the so-called “high order to trade” (HOT) traders and their trading activity on both Canadian stock markets and alternative trading systems from Aug. 1 to Oct. 31, 2011. IIROC found that about 11% of traders can be classified as HOT traders, entering a minimum of 11.2 orders for every trade and an average of 56 orders per trade.

However, the ratio is much higher for less liquid securities, reaching 1,000 orders per trade for many less liquid exchange-traded funds (ETFs) and notes (ETNs), for example. And, as the study notes, a handful of traders generated order/trade ratios of almost 10,000:1.

These HOT traders account for a disproportionate share of trading activity and message traffic overall. The IIROC study found that: HOT traders were responsible for 22% of trading volume during the period; they accounted for 32% of the dollar value traded and 42% of trades; and they generated 94% of the orders sent during the period.

IIROC found that the average volume and value per trade was lower for HOT traders (compared with the rest of the traders) but the average price per share for HOT trades was higher, indicating that HOT traders tend to trade in higher-priced securities. The study also found that HOT traders trade 36% of all Canadian share volume traded in U.S.-interlisted securities and account for 60% of all trading in ETFs and ETNs.

Within the HOT trader group, IIROC reports, about 40% were identified as direct market access (DMA) users accounting for more than their share of HOT trading activity. Notably, the study found DMA traders were responsible for 75% of the volume and value traded and 82% of the number of trades executed by all HOT traders.

According to a research note from TD Securities Inc., the fact that DMA traders represent less than half the number of HOT traders yet most of the activity suggests that many HOT traders probably are carrying out dealer market-making strategies.

The sort of HFT that regulators and others really may be worried about, then, is likely to be associated with DMA traders. Indeed, the TD report suggests that some DMA traders may be operating with unfiltered (a.k.a. “naked”) access to the market, which is a practice that regulators are trying to put an end to due to the systemic risk it represents.

The IIROC study attempts to classify traders as either “fast” or “slow,” depending on their response times, and it finds that 91% of the trading volume by HOT traders who also use DMA is considered fast, vs just 6% for non-HOT traders. (Overall, 84% of HOT traders are classified as fast.)

According to the TD research note: “Our take on this would be that it appears that DMA users are generally faster than non-DMA users, which suggests that DMA clients operating HOT strategies are de-facto better and faster than similar strategies operated within a dealer. It also seems likely that the DMA HOT fast users described are currently operating using naked access.”

As the TD report points out, naked access effectively will be banned as of March 1, when new rules governing electronic trading will take effect.

The IIROC study doesn’t draw any conclusions about the impact of any of its findings or whether there’s any need for regulatory intervention. Nevertheless, simply setting out to analyze the trading landscape objectively “is a very important step” in understanding HFT, the TD note says: “There is no doubt that our regulators are taking HFT seriously – and we commend them for it.”

The next step is to try to move to some conclusions about how this trading activity impacts markets, and whether it actually does harm ordinary investors and affect investor confidence.

IIROC is seeking assistance for this next phase of its study. Alongside its report on the first two phases, IIROC also has published for comment a proposed request for assistance (RFA), expressing its intent to seek help from interested outside parties, both academics and others, who have expertise in equities market structure in order to complement IIROC’s internal analysis.

The deadline for submissions from those interested in assisting with the next phase of IIROC’s study was Jan. 11. (No submissions were available as Investment Executive went to press.)

Once the final version of the RFA is issued, candidates will be given a month to submit proposals. And, after successful candidates are selected, IIROC anticipates that the final phase of the study will take eight to 10 months to complete. This means IIROC’s conclusions on the impact of HFT aren’t likely to be available until the end of the year, at the earliest.

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