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Regulatory Ambivalence

Mon, 28 Nov 2011 03:18:00 GMT           

 


Such were the stakes in the battles of the Persians over Greece. The development of freedom and self-government hung in the balance. So it is that, as another essayist has said, “A little of Leonidas lies in the fact that I can go where I like and write what I like.”
Chris Stewart and Ted Stewart, The Miracle of Freedom: Seven Tipping Points That Saved the World


Over the last 3,000 years there have been numerous inflection points that have set humankind on the steady march towards the liberties and freedom most of us take for granted. Chris and Ted Stewart, authors of The Miracle of Freedom wrote of seven historic tipping points, in each they saw the portent of a new age redefining and elevating individual liberties and justice. Those decisive events were plights that span victories in battle to the preservation of the collective intelligence from barbarous hordes, each one a stepping stone in the struggle against tyranny. One could debate that there certainly have been more than seven that shaped our present day sense of self-determination. Yet the author’s goal was not to describe all such cases, but to show how the conflicts precariously hung in the balance and succeeded only by a slim margin or a stroke of luck. And all too often the norm was tyranny and injustice and despots the ruling hand across most of the last three millennia.

Global regulators are once again under pressure to provide an explanation of the whipsaw volatility in the equity markets. There is growing vexation among traders and investors. The lack of confidence in the equity markets throughout much of 2011 can be seen in lower traded volumes. Regulators are looking to better understand the role played by high-frequency traders in the volatility. The U.S Congress and European parliaments have stepped in under political pressure and are looking to legislate through taxation. The proponents argue that it would slow down or eliminate high-frequency trading by wiping out their profit margins. The analyst firm Rosenblatt Securities estimates that HFT firms make about 1/20 of a penny per transaction. A 0.03% tax would destroy any chance of a profit, worse as Dennis Dick from Bright Trading describes it would hit quant-firms as well, those investing in technology and people and are not necessarily looking at ultra-low latency arb. Such legislation is a fool’s errand driven by the desire to find a convenient scapegoat.

Attempts to legislate presumed fairness will ultimately result in a loss of freedom for all. Scapegoating high-frequency trading will undoubtedly lead to more controls to the detriment of all market participants, exacerbating the vexations and market uncertainty regulators ultimately aim to end. Since the industrial revolution, segments of society have had an irrational fear of technology (i.e. luddites). Technological advancements have always been a double edged sword providing undeniable benefits for many and the end of a way of life for others.  Yet advances in trading styles have shown to have a positive impact. This is not to say, there are not a few bad actors. There have always been those focused on market manipulation long before the advent of high performance computer technology. But Black Monday didn’t lead to computers being banned and HFTs aren’t likely to go anywhere either despite political pressure to the contrary.

Regulators have to improve their understanding of market microstructures, the impact of algorithmic and high frequency trading in particular to introduce reasonable regulations. It’s been a year and a half since the well-publicized flash crash revealed the fragility of market structures. Since that time we have had restrictions (no more stub quotes) and price collars put in place to contain the outbreak of another one. There are countless academic papers on the subject as well. Yet one key contribution that could instill investor confidence is the deployment of the consolidated audit trail (CAT). Yet there appears to be little if any advancement towards that goal. Regulators seem to be ambivalent, or are they just proceeding cautiously?  Are they now distracted by the budgetary season as Congress looks for places to reduce deficits? Are the SEC and CFTC looking to safeguard
their base just when they should be ramping up on implementing reforms? The investment community wants definitive action. John Plender, mentions in a Financial Times article the need for a ‘regulatory verdict’ to once and for all determine if algo traders are manipulating prices creating toxic liquidity in the Lit Pools. Toxicity is not only in liquidity but in attitudes towards trading styles. The CAT could provide the needed granularity for surveilling and identifying market integrity issues. The scale and magnitude of the project is obvious, yet there is always that small first step.

Volatility is an irrational behavior; explanations for the whipsawing moves are levied on leveraged ETFs to fears over the European debt. The markets won’t accept irrational outcomes, such uncertainty creates a risk premium keeping the investment community sitting on the sidelines, as can be seen in the decrease in equity volumes and consequently contributing to a stalled economy. But the anxiety that manifests itself in the markets is really structural deficiencies in the overall economy and government divisiveness. The inaction and lack of leadership in Washington has resulted in a vilification of Wall Street. And that is not likely to end until the economy comes back. But we won’t see an economic turnaround until the courageous step forward to bridge the divide in Washington. As Thomas Friedman once said, leadership is hostage to its own ineptitude. A bread and circuses style of appeasement through legislative controls under the guise of fairness will continue to be proposed further tightening the reins.

In the book, The Miracle of Freedom, the authors conclude with a conversation about ‘this thing‘. Not something tangible, but a thought, a belief in something so precious to many but often overlooked by those born into it:

“… the Russian gestured again to the wonder all around him: the pleasant home; the constant flow of clean water; the dependable source of energy; the cars; the free press; the ability of the citizens to trust though they may not agree with the outcome., their elections were free and fair; the fact that one did not need to be a member of a certain party , or not be a member of certain religion, in order to avoid persecution; the fact that Americans did not fear a knock on the door at midnight; the fact that most Americans had great hopes for their children and their future – these are what the Russian officer meant by this thing.”


Once again thanks for reading.

Louis Lovas

For an occasional opinion or commentary on technology in Capital Markets you can follow me on  twitter, here.

 

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