September 11, 2012
With regards to regulation of High Frequency/Low Latency traders,
As a retail investor, I appreciate your effort to increase market stability, but I feel another related worthy goal is to increase the perception of a fair market. With the current market, it seems that some are a bit more equal than others. This has always been so, but today with the Internet, I would like to think this could be less so.
To this end, I request that you consider what appears to be called heartbeat trading as a solution to make equal access to the exchange more generally available. Given the right set of parameters and rules, this seems like it ought to have a good chance of success.
My understanding of heartbeat trading is that the exchange would use a periodic heartbeat to accept trade requests. All trade requests received prior to the beat would be processed just after the beat and the results distributed to all parties just after the beat. Assuming that there are no other information paths to or from the exchange and that there was sufficient time between beats for a reasonable subset of the investors, market makers, etc. to see the results of the last beat, think, and enter new transactions before the beat, then in theory, the system should be fair with respect to access to the exchange.
There will always be external events that some become aware of before others. I don't know how to help this except that if in a given beat the orders indicate something is bonkers (a published, predefined critera), then it might be a good idea for the exchange to choose to publish the situation and disregard orders for a published number of beats for everybody to have a little extra thinking time. (Different levels of 'bonkers' might result in different amounts of thinking time, but the idea is to keep the exchange open, perhaps at a lower beat rate.)
My hope is that this will increase stability for two reasons. First any useful trading system can become unstable if the traders put in trades to cause it to become so. Hopefully there is no rational (or maybe legal?) reason for traders to do so, but recent market events have shown that with the current state of computer driven trading it can happen. The thinking time between beats should provide the opportunity for rational though to counteract this sort of event. Second, the extra thinking time during market stress should reeinforce this opportunity and in effect give everybody a Mulligan.
As for tuning parameters, there are two. One is the basic beat rate. Personally I would vote for 5 seconds, but I can see that this might be impractical for the market as a whole. I think to get the benefits of rational thought, it needs to be at least 1 second. From a physics standpoint, a few tenths of a second is probably the fastest that allows the exchange state to be distributed to a reasonable number of interested parties. The second paramters is the rate of Mulligans. I don't think these should be rare. Perhaps a few minor ones a day so everybody has a chance to learn how to react when they happen.
Hopefully this will at least set the bar in terms of stability, transparency and fairness for whatever other proposals show up in this process. Since markets don't react kindly to sudden upsets, I presume whatever you choose will be carefully analysed, tweaked, and gradually phased in to give the market a chance to adjust to the new methods.
I understand that this proposal would make it difficult or impossible to do HFT. As a regulator this may make the proposal equally difficult to implement. One strategy for resolving this might be to figure out a carefully defined positive market function for the HFT folks to provide. Perhaps extraordinary access to the market should only come with extraordinary responsibilites.