As Europe, Canada Try To Control Bot Traders, The U.S. Falls Behind

15 january 2013

Word that Europe, Canada and now Australia are taking steps to curb the power of high-speed algorithmic traders should be of little surprise.  Aside from last decade’s explosion of bot trading in the United States, European markets and others have normally been a step ahead of the American markets in utilizing and understanding technology.

Europe was the place Thomas Peterffy, the programmer who made himself into a billionaire, turned to after hacking the Nasdaq in 1987.  Frustrated with the collusive forces that controlled American markets and kept technology out of them in the early 1990s, he began taking on markets in Germany, the UK and other spots.  Back then, there was still a great amount of utility to be gained by automating some aspects of trading.  Doing this brought trading to the normal man’s laptop for $7 a trade

But we’ve had cheap trades for more than a decade.  The utility of going faster, faster and faster, at this point, has been exhausted.  We may have not reached terminal velocity, but we’ve reached terminal efficacy as it relates to speed.  Shaving a millisecond—or, as some technologies seek to do, a mere microsecond—benefits nobody except the guy stepping in front to make the trade.

Additional speed, at this point, only introduces more risk into our markets.  Risk of catastrophic failure, rick of chaos, risk of circus displays like the flash crash of 2010 that, while some market people call the episode harmless as the market did recover most of its losses rather quickly, they underestimate the steady erosion of the public’s trust in our markets.  When retail and institutional orders taper off, the algo traders cease to have anybody to play with; algos can only trade nickels amongst each other for so long.  Such an outcome is bad for everybody – including the companies that normal people want to own: Apple, Google, Wal-Mart, Exxon Mobile.

European regulators have suggested making rules that make traders keep a bid or offer live for at least half a second, which amounts to an eternity to U.S. algo traders, most of whom spend more time faking out opponents by cancelling trades as soon as they’re offered than actually offering trades they want executed.  The deluge of orders, most of them irrelevant, has pushed our exchanges to the breaking point.  Data pipes are overbuilt to the point of hilarity. By making people offer trades that they actually want executed, which is what a half-second minimum would do, the Europeans could restore some sincerity to their markets.

Canadian regulators also have a novel approach: they’ve suggested charging traders for the amount of data they fire at exchanges.  A “fake” order will no longer be free, which will discourage the strategy of “quote stuffing” to overwhelm competitors who employ inferior hardware and software that can’t parse the data fast enough.

The free-markets-forever crowd will yell that these strategies somehow threaten our markets’ freedom, but that claim seems rather hollow.  The markets charge traders now for all matters of things: co-location, faster data feeds, trades that are actually executed.  Taking a fee for every trade fired at an exchange would remove some of the haze that surrounds our market structures that have grown so esoteric that big trading firms must woo particle and quantum physicists to its fold.

The stock markets were designed to get money to growing companies that could put it to best use and, in the process, give normal people a way to invest their cash in vehicles with the potential for growth.  There’s always been risk involved, but that risk came purely from the company being invested in, not from a labyrinthine market structure that requires a Ph.D. to navigate.

A couple of simple rule changes could go a long way toward healing the foibles of our markets while retaining the efficiencies of the algorithm-driven bots that have come to rule them.

So now, strangely, the United States can sit back and observe the leadership of Canada.