Contributor: Chris Lees
On March 27th the 2011 Formula 1 season kicks off with the Qantas Australian Grand Prix. Each of the teams will have spent untold millions of dollars refining their cars to be as fast and as aerodynamic as possible. The drivers will study the tracks and other drivers carefully, plotting and memorizing the optimal driving lines, and when the race day arrives they will constantly drive at the edge of their ability in their bid to win pole position. Speed is everything in this game and anything – from the tilt of a fin to the flow of air over the nose – can give the vital, incremental advantage needed to win. But driving at such speeds carries very serious risks both for the drivers, those around them, the spectators, and ultimately the reputation of the sport. That’s why each year the Fédération Internationale de l’Automobile (FIA) issues a set of rules designed to promote safety and fairness between the teams by strictly governing the design and performance of the cars. On February 3rd the FIA published fifteen such technical rules for the 2011 season – four based on safety considerations and eleven addressing fairness. Together they control detailed technical specifications such as the placement of rear-view mirrors, minimum chassis height and the aerodynamic design of rear fins.
Does any of this sound familiar?
In the global financial markets we have a burgeoning number of secretive, high frequency traders who are spending untold millions of dollars on their obsession to shave fractions of a millisecond off their round-trip times. Tricks of the trade include venue co-location, straightening the fiber-optic cabling from Chicago to New York, printing logic directly onto silicon chips, and intensive use of complex computing to identify pricing anomalies across an expanding range of asset classes. These firms grew both in number and dominance since the turn of the millennium while regulations barely registered (or controlled) their emergence. Imagine a world in which Formula 1 cars are allowed to drive on the nation’s highways!
On May 6th 2010, however, the world changed when the Dow went into free-fall only to bounce back minutes later. Nine months on and the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues recently issued a report containing 14 recommendations (pdf download) following the crash which – like the FIA’s rules – can be read to be a mixture of safety and fairness considerations. Market safety recommendations include the extension of circuit breakers and closer scrutiny of pre-trade risk checks, while fairness is addressed by proposals to review payment for order flow arrangements, and to investigate varying venue maker/taker fees to incentivize continued liquidity during periods of market stress. The committee does not suggest that high frequency traders caused the crash, but their conclusion is that their presence (and withdrawal at the critical moment) amplified the market swing, and that by extension their participation in the market should be controlled more tightly in the future.
So will the financial markets ultimately adopt regulations similar to Formula 1? Can fairness be achieved by regulations governing the power or size of an algorithmic engine, or mandating the minimum length of cable between it and an exchanges matching engine? I don’t think so. But what is clear is that the regulators are taking an increasingly concerned view of the rapid evolution of market structure, and are seeking to impose greater discipline and specific, measurable controls on their operation. The financial impacts of these recommendations are likely to be felt most by the high frequency community whose ability to win may rely on technical advances which are curtailed by new regulations – much like the challenges faced by Formula 1 racing teams.
At this point it is not clear what the future holds, but we will most likely continue to see increased regulatory change for many years to come, and that these changes will focus on standardization and controls designed to promote fairness as well as safety. What does this mean for the high frequency trading community? Well I’ll leave you with one final Formula 1 fact that paints a gloomy outlook. There are just 12 teams racing in the 2011 season – a thirty year low – and all of their cars are powered by just four engine manufacturers. Why? Sixty years of increasing regulation and an accelerating technical arms race have taken their toll, and made it exponentially more difficult (and expensive) to win with consistency. Teams have been forced to slash costs and/or face bankruptcy or sale. Is this the start of the end for the high frequency trader?
* The summary report from the joint committee can be viewed at http://tinyurl.com/4ghahyn (pdf download)
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