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.


Vanguard argues that reforms to current market structure could focus on two areas.

“We believe that publicly displayed liquidity is the foundation of a transparent and efficient market. Changes to regulations could better promote the public price discovery process. Such changes could include a ‘trade at’ rule and the removal or revision of exchanges’ current ‘maker-taker’ pricing model,” Joseph Brennan told

Some HFT firms agree with Brennan’s first suggestion.

“Many traders would support a ‘trade-at’ rule, which means that you’re not allowed to trade away from the lit—public—markets unless you offer a significant price improvement,” said one employee of an electronic trading firm, who requested anonymity.

“Such a rule already exists in Canada and Australia. But this should occur hand in hand with a reduction in the regulatory cap on the fees payable to access the public exchanges.”

But IMC’s Lenterman told that those seeking reforms to the ‘maker-taker’ exchange fee system (under maker-taker, firms posting bids and offers on the exchange order book—makers—receive cash rebates for doing so, whereas those removing liquidity—takers— pay a fee) should proceed with caution.

“95% of all exchange-based trading volumes in the US occur under the maker-taker fee model,” Lenterman said.

“But there’s a very high level of what we call ‘adverse selection’ on the lit—public—exchanges,” Lenterman continued.

“A lot of the client flow that we as market makers like to trade against now occurs on dark pools or other internalised trading venues. The flow that does find its way to the lit exchanges tends to be what we call ‘exhaust flow’ and often works against market makers. For example, if I bid for something at 10, five minutes later it may be worth 9.”

“The maker-taker model compensates market makers for providing liquidity on the lit exchanges, but I’d estimate that up to 80% of the rebates received by market makers are eaten up by this adverse selection effect. This leads to market makers being more selective in providing liquidity. So if you take the rebates away, the visible liquidity in the order book will become less.”

From a European perspective, the current HFT debate seems US-centric; Europe has no equivalent of Regulation NMS.

“There is no consolidated Europe-wide quote and there is no obligation for one European exchange to route orders to another if there is a better price there. In Europe there’s arguably a level playing field: everyone tries to get to the nearest exchange as fast as possible,” Flow Traders’ Rietberg told

Some market participants would support the creation of a Europe-wide consolidated feed of exchange quotes.

“Having a single European order book and linking trading venues to ensure trades are rerouted if there’s a better price elsewhere would ensure a more competitive market and ultimately help investors,” Keshava Shastry, head of capital markets at Deutsche Asset and Wealth Management, told

However, IMC’s Lenterman sounded a note of caution, warning that European policymakers should avoid repeating the US experience.

“In Europe, the incumbent exchanges still have 60% or more of the trading volumes in major shares, so you could argue that some more competition would be welcome. But I’d never want to go to the US situation of protected quotes, where you create a new venue and suddenly everyone has to connect to it,” said Lenterman.

Although ETFs received just a single mention in ‘Flash Boys’, the current HFT debate carries an existential importance for exchange-traded funds, stresses IMC’s Lenterman.

“The difference between an ETF and an equity is that an ETF is a purely quote-driven instrument. It cannot live without its market maker. There wouldn’t be any ETFs without high-frequency trading,” he said.



















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