There have been many articles in the media saying that SEBI might introduce minimum resting time for any order before it could be cancelled. A report by Santa Fe Institute written J. Doyne Farmer and J. Doyne Farmer is a detailed writeup on the various aspects one must think about, while meddling with the market micro structure. The opinion expressed by both the authors is in the context of European markets.

The key premise on which the authors build their argument is by highlighting the difference between absolute speed and relative speed. Market quality is determined by absolute speed whereas private benefits of speed comes from relative speed. What society cares is absolute speed. Markets are already far beyond the absolute xspeed needed to maintain market quality.

The author say that the current empirical research on the HFT’s impact is mixed. Acknowledging the limitations current empirical evidence has for evaluating the effects of HFT, the authors base their arguments about the effect of market speed on theoretical reasoning from first principles.

What would happen if there is no intervention to contain market speed?

One opinion that we get to hear very often is that market will find a way to create a solution for this race for speed. Well, the competition will make sure that the profits and the corresponding investments in technology will reach a point where relative speed and absolute speed will have a certain stable relation. The author argue that there are no theoretical reasons why current levels of speed confers significant benefits to the society at large. How does investment in a biotech company that takes years to churn out profitable product, become better if one receives information a few milliseconds or microseconds earlier. There is also no obvious reasons why trading a stock at a nanosecond latency should generate effective information transmission than a lower speed of trading?

At least theoretically there are convincing reasons that say that not regulating HFT could be harmful

  • Speed has value in the financial markets, but the current levels of speed is giving rise to perverse systemic outcomes. Exchanges who are hungry for higher turnover play to the HFT gallery who in turn ramp up the speed levels to get the best out of their expensive tech investment, that depreciates exponentially
  • The emergence of darkpools is a clear indication that there is a significant market participant group that don’t care about latency and are more worried about execution performance. They don’t want to end up as preys to the so called HFT predators
  • It is hard to argue against the statement - speed creates trade-offs which in turns creates risks
  • Speed creates a massive entry barrier for startups as the investment needed to get to the prevalent latency levels of market keeps going higher and higher. This is unlike tech space where open source has created a level playing field where innovative ideas and services thrive.
  • There is also evidence that policy to eliminate barriers to entry have had positive effects. See the paper leveling the trading field
  • Speed can cause systemic instability and collapse. Since it is widely acknowledged that HFT strategies across firms are highly correlated, there is a potential for a systemic risk.
  • Speed causes an arms race where it is winner-take-all situation

If we look at all the above reasons, they are all theoretical ones. The reason for the lack of empirical evidence is also a harsh reality of the market place. The regulator cannot match up the tech infrastructure that HFT firms have. Flash crash happened in 1/2 hr and it took 6 months for SEC to bring a report on it. In India I guess if such a crash happens, do we know that SEBI has the right kind of people and infrastructure to figure out the problems? The other day, someone was mentioning that SEBI is used to policing various entities and most of the personnel at various levels are from Income Tax background, i.e. they can vet the balance sheet, income statement all company related books thoroughly. In the case of market failure though, it appears that they need to ramp up their investments in tech as well as people.

Potential Benefits of a minimum resting time

  • will make limit order book more stable
  • easier market monitoring
  • having a predictable environment
  • manipulative strategies like layering and spoofing will become harder

Potential costs of a minimum resting time

  • substantial advantages to aggressive orders at the expense of passive traders
  • significant increase in bid-ask spread
  • raising transaction costs
  • increased volatility
  • unfair to impose a regulation that will clearly benefit one type of HFT technology(aggressive) at the expense of other(passive)
  • change might drift away activity to other markets

The authors opine that negative effects will FAR outweigh the benefits and conclude that the proposal of minimum resting time is a terrible idea.