Don’t Tip the Trading Table (Hillary)

There has been much talk about making markets fairer, with perhaps Michael Lewis’ “Flash Boys” being the signal event last year, with its assertion that flash trading is rigging markets (and associated opining on what to do about it). There do seem to be more and more mini-flash crashes of late and associated enforcement efforts, some of which create flash patsies. Much has been made of reduced capital commitment and a lopsided U.S. fixed income market. EU debate is always bubbling about financial transaction taxes (FTT). And now none other than U.S. presidential candidate Hillary Clinton (advised by her campaign CFO Gary Gensler formerly of the CFTC and Goldman Sachs) has weighed in on the subject:

Impose a high-frequency trading tax and reform the rules that govern our stock markets. The growth of high-frequency trading (HFT) has unnecessarily burdened our markets and enabled unfair and abusive trading strategies that often capitalize on a “two-tiered” market structure with obsolete rules. That’s why Clinton would impose a tax targeted specifically at harmful HFT. In particular, the tax would hit HFT strategies involving excessive levels of order cancellations, which make our markets less stable and less fair.

Clinton would also reform our stock market rules to ensure equal access to markets and information, increase transparency, and minimize conflicts of interest. Over the last decade, equity markets have become less transparent—often serving the interests of high-frequency traders and ‘dark pool’ operators at the expense of the investing public. Clinton is calling on the Securities and Exchange Commission (SEC) to pursue reforms that ensure that these markets are putting the interests of the investing public and corporate issuers before those of high-frequency traders and financial firms.”

She goes on to say in an op-ed that “we need to ensure that everyday investors and consumers can trust that our financial markets work for them—and not just for insiders with the most sophisticated, specialized and fastest connections. That is why we should impose a tax on the high-frequency trading that makes our markets less stable and less fair. And we should reform the rules that govern our stock markets to ensure equal access to markets and information, increase transparency, and minimize conflicts of interest.”

That bugaboo, the everyday investor … does she mean day traders? She couldn’t be referring to those huge asset managers like BlackRock or Pimco—in which so many individuals invest via 401(k)s, mutual funds, and ETFs—could she? We shall see how serious such red-meat proposals are, though this latest one certainly seems to be lacking in meaty details on the bone.

In the rush to right supposedly rigged markets, we need to maintain their delicate balance and be careful not to tip or eventually topple them. Always beware of the law of unintended consequences … no matter how well-intentioned a regulator, it can never really be sure of the ultimate results of what seemed like a good idea at the time (e.g., maker-taker and the HFT explosion). To this end, it would be helpful to think of capital markets as a table composed of five broad legs, which, while individually very aggressive, work together to keep markets in balance.

Buy-side:

  • Asset manager
  • Hedge fund
  • Insurer
  • Mutual fund
  • Pension/401(k)

Market-making:

  • Designated market-maker
  • Quasi market-maker HFT

Market:

  • ATS
  • Dark pool
  • ECN
  • Electronic trading platform
  • Exchange
  • SEF

Proprietary trading:

  • Hedge fund
  • HFT
  • Principal trading firm

Sell-side:

  • Agency broker
  • Bank
  • Broker-dealer
  • FCM

Each of those five bring something to the table and help stand it up. Were any one leg to become too strong or too impaired (or overtaxed), capital markets may become unbalanced. There will always be informed and uninformed trading, and that’s OK, so long as each is roughly the equal of its opposite.

One would think from all this hubbub “HFT bad, brokers good.” Um, no that can’t be, with too-big-to-fail/jail banks. Maybe it’s just the retail investor being hurt. Um, no that can’t be, when algo and HFT are so fundamental to maintaining order in the ETFs, much loved by today’s everyday investor. What HFT are we all talking about anyway … is it the HFT that has taken the place of old-fashioned market-making? Or do those proprietary traders only play with their own money (money which some presidential candidates enjoy so much)? It certainly is confusing, and not just to the everyday investor.

While FTT and HFT taxes may seem appealing to some, any resulting shortening or dislocating of one or more of those five trading table legs may give rise to far more unbalanced markets down the road than advocates for such proposals seem to think are being rigged today. Each of these market participants can be seen as very aggressive on its own, even dangerous from a certain point of view, but together they all serve to keep each other in check and deprive any one or two primacy over the rest. Market participants, regulators, law enforcement, and politicians should never lose sight of this delicate balance and the need to exercise discretion in choosing to advocate for anything designed to make markets “fairer,” lest they inadvertently upend them in the process.

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