How speed bumps are curbing high frequency traders
Is a new hurdle adding fairness or degrading market quality?
‘Need for Speed’ is the most successful street car racing video game of all time, selling 150 million copies since 1994. The title is equally apt for today’s high-tech race between traders on stock exchanges where specialised high frequency trading (HFT) firms use cutting-edge technology to snap up the best prices before slower traders can.
The 2014 New York Times best-selling novel Flash Boys by Michael Lewis criticised exchanges for allowing HFTs this advantage.
Unlike Australia, where there are two main stock exchanges, in the US there are multiple stock trading venues. There, institutional investors, buying or selling a big block of shares, commonly split the order across a number of stock exchanges in search of a better overall price.
HFT algorithms can observe the order on one exchange and race the investor to the next one, buying up the available stock there and selling it on at a slightly higher price. About 50% of today’s trading on US stock exchanges is estimated to be done by HFTs.
A 2015 study by Eric Budish and co-authors describes the present system of continuous time trading as encouraging a never-ending, socially wasteful “arms race for speed”.
For example, in 2010, Spread Networks spent US$300 million on a new high-speed fibre optic cable connecting financial markets in New York and Chicago in a straight line to cut 3 milliseconds (ms) off the 16ms round-trip communication time.
By the following year, that investment was made obsolete by microwave technology, which reduced transmission times by another 6ms.
Stock exchanges also profit from the “arms race” by selling space to these high frequency traders’ computers, located as close as possible to the stock exchange computers, in the hope of shaving microseconds from transmission times and gain an edge on competitors.
Slowing them down
The hero of Flash Boys is a real-life young Bank of Canada stockbroker in New York named Brad Katsuyama, who decided in 2012 to take on the HFTs that kept beating him to the draw when he traded shares for superannuation funds, costing members money.
He set up an alternative trading venue, IEX. It featured a ‘speed bump’, which slows down trades by 0.35ms – which was long enough to prevent HFT firms from rushing in ahead of the trade made on his exchange.
Since IEX’s recent approval as a fully fledged exchange, other stock exchanges are following suit. US markets NASDAQ, NYSE and CHX are all at various stages of having their own speed bumps approved by regulators.
So, after a decade of adopting technology to speed up trading – almost to the limit (the speed of light) – markets are now taking speed bump measures to slow them down. And because some traders can pay to be exempt from speed bumps, thus gaining a speed advantage over others, this is hotly debated in the industry.
Now criticism has come from Thomas Ruf, a senior lecturer at UNSW Business School, and PhD student Haoming Chen – in joint work with Sean Foley from the University of Sydney and Michael Goldstein from Babson College – who investigated the introduction of a speed bump in 2015 by TSX Alpha, a major exchange in Canada, in their paper, The Value of a Millisecond: Harnessing Information in Fast, Fragmented Markets.
The authors conclude that speed bumps have the potential to negatively affect trading costs for large investors and deteriorate market quality overall.
'Being able to avoid those loss-making trades with opportunistic traders should encourage liquidity providers to provide more liquidity at better prices for other investors'THOMAS RUF
An additional twist
Most of the present speed bump designs are discriminatory, or asymmetric, in the sense that they allow fast providers of liquidity (typically HFT firms) to pay to avoid the delay and give them a ‘last look’ option.
That is, in the time it takes for regular market buy and sell orders by, say, institutions to traverse the speed bump, liquidity providers can evaluate recent trading activity on other venues and decide whether they want to trade or cancel their liquidity without being subject to the speed bump.
“There are some good intentions behind this feature,” argues Ruf. A speed bump can prevent other, predatory traders from picking off outdated quotes by a liquidity provider before she can adjust them (quote sniping).
“Being able to avoid those loss-making trades with opportunistic traders should encourage liquidity providers to provide more liquidity at better prices for other investors,” Ruf says.
However, it may also allow liquidity providers to evade large orders by institutional traders who are merely trying to access the advertised liquidity on that venue, but whose sheer size tends to move prices against liquidity providers.
TSX Alpha’s speed bump adds an additional twist by randomising the length of the speed bump between 1ms and 3ms. This makes it difficult for institutional investors to synchronise the arrival of their orders across venues giving liquidity providers time to react.
This is exactly what Ruf and his research colleagues find: close to 80% of initially displayed liquidity on Alpha is cancelled during trading events (compared with 20% prior to the introduction of the speed bump).
Institutional trading is greatly reduced, while Alpha subsequently attracts a lot more trading by retail investors, whose order flow tends to be uninformed and does not systematically move prices.
“Alpha’s liquidity providers strategically avoid loss-making institutional order flow and hence increase their profitability immensely on that venue. This segmentation of trading, however, leaves the remaining venues to absorb relatively more ‘toxic’ order flow,” says Ruf.
Despite TSX Alpha’s modest 7% market share, there are measurable consequences for other venues and the market as a whole. Faced with more loss-making trades, liquidity providers on the remaining venues widen the spreads they offer – that is, make it more expensive to trade for everybody.
'Randomised speed bumps may not be such a good idea as they impede the ability of large institutions to efficiently access liquidity across venues'THOMAS RUF
The study further finds an increase in order book fragility – that is, the likelihood that offered prices move away from traders sooner, who then have to execute more at inferior prices.
“In theory, as liquidity providers on other venues retreat, competition should force liquidity providers on Alpha to narrow spreads, but Alpha’s speed bump is only useful when it is not the first venue to receive orders as you want that ‘last look’. Offering a better price negates the whole point of the speed bump,” explains Ruf.
Ultimately, not all speed bumps are created equal. The speed bumps for American stock exchanges IEX, CHX, NYSE, NASDAQ and Alpha all differ subtly in their construction.
“I think our study clearly demonstrates that, among all possible designs, randomised speed bumps may not be such a good idea as they impede the ability of large institutions to efficiently access liquidity across venues,” cautions Ruf.
Some voices in the industry have called on US regulators to abandon a long-standing tenet of US markets, known as trade-through prohibition. It forces traders to route orders to any venue that currently displays the best price, even if that venue’s speed bump makes reaching that price in time illusory.
Canadian regulators made up their minds early. Because of its speed bump, Alpha is no longer protected from trade-throughs – that is, traders can choose to ignore its quotes.
However, the research authors are not convinced that this alone solves the problem: “Removing a speed bump venue from protection does not automatically neutralise its potentially negative spillover effects as the case of Alpha demonstrates. As long as some traders find the venue attractive, it can affect the overall market equilibrium. Speed bumps will keep regulators busy for some time to come.”
At this stage, there are no speed bumps on Australian stock exchanges.