It’s Structure, Not HFT That Needs Fixing

April 22, 2014

According to the  head of Vanguard's Global Equity Index Group, the world’s largest manager of mutual funds, the current debate over high-frequency trading (HFT) risks missing the point.

“HFT is just one part of a bigger topic—market structure,” Joe Brennan told in a telephone interview.

The central theme of Michael Lewis’s new book on HFT, ‘Flash Boys’, is that the US equity market is rigged, with electronic trading firms routinely jumping ahead of and exploiting investors’ orders. The “icon of global capitalism” —the US stock market—has become a fraud, Lewis argues.

According to Vanguard’s Brennan, to understand the rise of HFT it’s important to remember just how radical the US reforms of share trading have been.

“Over twenty years we’ve moved from a fairly monopolistic market structure to a much more fragmented marketplace, via Regulation NMS,” Brennan told

Regulation NMS (National Market System) is a set of rules brought in by the US stock market regulator, the Securities and Exchange Commission, in 2007.

The central requirement of Regulation NMS is the so-called Order Protection Rule: orders to trade in a stock or ETF arriving at an exchange with an inferior price must be rerouted for execution on an exchange with a superior price.

By requiring the automatic rerouting of orders, Regulation NMS has led to an explosion of trading venues—over 60 by some estimates—and multiple electronic linkages between them. The Regulation also brought in a concept called the National Best Bid and Offer (NBBO) in any exchange-traded security.

Lewis provides ample evidence in ‘Flash Boys’ that these regulatory reforms have created opportunities for trading firms with faster connections (or a superior ability to code instructions for routing trades) to gain an advantage over others.

Stock exchanges, meanwhile, most of which became profit-making entities during the last decade, have been happy to sell “co-location” services—the ability to place computer servers close to the exchanges’ own data processing units—to trading firms. Exchanges have also created many new order types designed specifically for firms executing share transactions by electronic algorithm.

Such practices have helped fuel suspicions that certain HFT firms have gamed the rules to enjoy an unfair advantage over others.

Vanguard, however, refuses to criticise electronic trading per se.

“Competition and technological advances have brought trading costs down for end-investors, which is good news,” the firm’s CIO told

“Some high-frequency traders, as well as brokers, play a role in knitting back together a fragmented market structure. But there are other HFTs who may be unfairly taxing the system through their behaviours,” said Brennan.

The chief operating officer at Flow Traders, an electronic trading firm, stressed that in itself HFT is simply a way of executing orders.

“HFT is just a tool—something used to execute certain trading strategies. From the perspective of the overall market, these strategies can either add or remove liquidity,” Sjoerd Rietberg told

In the opinion of Remco Lenterman, managing director at IMC, another electronic trading firm, the controversy over HFT could have harmful side-effects.

“Arbitrage is always about latency,” Lenterman said in a phone interview.

“The first one to capture a fleeting opportunity will be the winner. My main concern about Michael Lewis’s book is that the whole activity of arbitrage is now being seen as potentially predatory behaviour. This could be very damaging, especially for ETFs, which rely on arbitrage.”

But Regulation NMS has encouraged fragmentation to the detriment of the overall equity market, Lenterman concedes.

“The main issue in the US is that it’s been too easy to start a new exchange, receive immediate quote protection and a share of the $400 million annual revenues deriving from the SIP, the consolidated feed of quotes from all US exchanges. A number of exchanges are effectively living off the SIP revenue and there’s an unhealthy economic incentive to add to the current market fragmentation,” said Lenterman.

“Many trading firms agree that this fragmentation has gone too far,” Lenterman concedes.



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