Subject: File No. S7-02-10
From: R T Leuchtkafer

April 16, 2010

Thank you for the opportunity to comment on the SEC's Concept Release on Equity Market Structure ("Release"). The last 15 years have seen a radical transformation of the equities markets from highly concentrated, semi-automated and intermediated marketplaces to highly distributed, fully automated and nominally disintermediated marketplaces. Along with or because of these changes, we have seen the rise of new classes of very profitable, aggressive, and technologically savvy participants previously unknown in the U.S. markets. When markets are in equilibrium these new participants increase available liquidity and tighten spreads. When markets face liquidity demands these new participants increase spreads and price volatility and savage investor confidence.

These participants can be more destructive to the interests of long-term investors than most have yet imagined. While the Release states many of these participants have always existed and have always traded the way they do, this is not true. Technology has dramatically changed the effect and dominance of their behavior in the markets. To adapt a famous construction, technology changed markets the way gunpowder changed the velocity of lead. It is obviously a qualitative change.

Someone once suggested the real scandal is often not what is illegal but instead what is legal. What is legal in today's market includes an exchange that sells real-time data to high frequency trading ("HFT") firms telling those firms exactly where hidden interest rests and in what direction. What is legal is the replacement of formal and regulated intermediaries with informal and unregulated intermediaries. What is legal is the proliferation of high-speed predatory momentum and order anticipation algorithms unrestrained by the anti-manipulation provisions of the Exchange Act. What is legal is a market structure that dismantled the investing public's order priorities and gave priority to speed and speed alone and then began charging for speed. What is legal is the widespread lack of supervision of the most aggressive and profitable groups of traders in American history. What is legal is exactly what the Release says it is worried about, "a substantial transfer of wealth from the individuals represented by institutional investors to proprietary firms."


Here is a thumbnail history. Beginning in the late 1990s and in answer to the largest market center scandal to date (a quote-rigging scandal at FINRA's predecessor) the SEC forced Nasdaq market makers to post any customer orders priced better than the market maker's own quote or to pass those customer orders off to a new kind of entity called an Electronic Communications Network or ECN. The fin de siecle quote-rigging scandal certainly was a transfer of wealth from investors to dealer firms and public disgust with intermediated markets led us down the path to disintermediation. The thinking behind it was plain and well-supported by reformers at the time. If intermediaries were cheating their customers, let customers trade directly with one another. ECNs stepped into the gap. With an emphasis on fast, disintermediated executions, with price/time order priorities, and with an emerging technology base that supported vast amounts of order transactions, the ECNs were a food plot for a new class of market participant, the market making HFT firm. In their infancy and suffering from poor quote quality, the ECNs courted HFT firms as unregulated market makers and a business model was born. ECN pricing changed to enhance these new business models. Over time as ECNs grew and started crowding out the established exchanges, ECNs became or combined with exchanges to leverage certain exchange regulatory and economic preferences and the high-speed, disintermediated, flat price/time order book HFT-dominated exchange was born. HFT firms invested in ECNs and exchanges, sat on their boards, and held considerable influence over their design and operation. By 2010 this HFT-dominated market structure and business model functionally replaced that of the 20th century exchanges.

What is Legal - Shooting Elephants

A classic short-term trading strategy is to sniff out an elephant and trade ahead of it. That is front-running if you are a fiduciary to the elephant but just good trading if you are not, or so we suppose.

Nasdaq sells a proprietary data feed called TotalView-ITCH that specifies exactly where hidden interest lies and whether it is buying or selling interest. Nasdaq does it via a trade message specifically for hidden interest and the message includes a buy or sell indicator telling the direction of the hidden order that just traded, the "type of non-display order on the book being matched." This has been a feature of TotalView-ITCH for years. According to Nasdaq a "non-display order" is "hidden from the marketplace." This kind of order is designed primarily for traders with size or with prices better than the displayed prices already in the market. They are often institutional traders, the buy-side. In their comment on the Release, Angel, Harris, and Spatt write "many buy-side traders have enthusiastically supported innovative hidden order types..."

Nasdaq says "Within the market data industry, TotalView-ITCH sets the standard for low latency depth data feeds." Market making, statistical arbitrage, order anticipation, momentum and other kinds of HFT firms are an obvious customer base for this product.

Reflecting on this, a stock exchange has implemented a market structure rewarding speed. It leases space and facilities to firms who want to be as fast as possible. The stock exchange developed a data feed containing details on all of its displayed orders and on all of its trades. For its institutional customers it implemented a non-displayed order type so the institutional customer can be in the market without showing its hand. For its HFT customers it discloses trades against these institutional non-displayed orders and the direction of the non-displayed order. It even adds a synthetic order number stamped on trades so HFT firms can total up executed volume by order as the order is executed. The fastest HFT firm to take advantage of it all wins.

This data is certainly known to the HFT community. It is also known to the academic community as several papers use it in their analyses. It is largely unknown in the buy-side community. Nasdaq is not shy about advertising it as a feature of TotalView-ITCH since it is mentioned on the first page of the current TotalView-ITCH specification. (Other exchanges implemented this same data feed without divulging customer hidden orders.)

The SEC must do an analysis and estimate whether and how much this data field has cost investors over the years as HFT firms found hidden interest and ran ahead of it. The SEC should also ban this field immediately and insist hidden order execution is reported in proprietary data feeds without disclosing the direction of the hidden order and without synthetic order numbers.

What's Legal - Unregulated Intermediaries

In 2000 as the HFT revolution started, dealer participation rates at the NYSE were approximately 25%. In 2008, the year NYSE specialists phased out, HFT participation rates in the equity markets overall were over 60% according to the Aite Group. The dealers at the NYSE were regulated specialist firms. The dealers in the decentralized and fragmented equity markets today are unregulated HFT firms.

The regulatory environment for dealers in 2000 was very different from the HFT firms who act as dealers today. Historically, dealers faced several restrictions meant to keep dealers from moving the market ahead of customer orders. At a given price, customer orders had priority. Depending on the market center, dealers had affirmative obligations to maintain price continuity and negative obligations to yield to customer orders. Dealer trading activity, capital adequacy, and trading positions were regularly and extensively monitored. In exchange for these regulations, dealers often had certain privileges, including monopolies at their market center and control over the order book.

A HFT market making firm does not need to register as a market maker on any exchange. To the regulatory world it can present itself as just another retail customer and make markets with no more oversight than any other retail customer. Aside from capturing spreads, market centers pay these firms for supplying liquidity and the liquidity they supply becomes part of market center business models. Some HFT firms do register as market makers. By doing so they get access to more capital through higher leverage, they might get certain trading priority preferences depending on the market center, and they get certain regulatory preferences. They are usually required to post active quotes but quote quality is up to the market center itself to specify and some market centers have de minimis standards. Other than these quoting standards, formal HFT market makes have little or none of the regulatory oversight of the old dealers. They do not have any meaningful restriction on moving the market, they have no meaningful capital adequacy standards, no obligation to yield to customer orders, no meaningful obligation to maintain competitive quotes, no dealer position monitoring, nothing. A formal HFT market making firm can listen to that Nasdaq data feed mentioned earlier, for example, learn that there is hidden interest in a stock, and immediately start buying or shorting that stock aggressively and it is perfectly legal. In 2008 market centers paid over $2 billion in liquidity rebates alone, with most of these payments going to HFT market making firms, while HFT firms as a group were estimated to take home $20 billion in profits. As a comparison, in 2000 NYSE specialist firms had slightly more than $2 billion in total gross revenues.

Formal and informal market makers in the equities markets today have few or none of the responsibilities of the old dealers. That was the trade-off as markets transformed themselves during the last decade. In exchange for losing control of the order book and giving up a first look at customer order flow, firms shed responsibility for price continuity, quote size, meaningful quote continuity or quote depth. The result is that firms are free to trade as aggressively or passively as they like or to disappear from the market altogether. They still get valuable privileges if the register as market makers, and they promise in return to merely post any quote, and a penny bid can count as a valid quote.

HFT firms claim they add liquidity and they do when it suits them. (Remove the effects of very active penny stocks like Citi and AIG from crisis and post-crisis SP500 spread and depth studies and you can dispute HFT liquidity claims.) At any moment when they are in the market with nonmarketable orders by definition they add liquidity. When they spot opportunities or need to rebalance, they remove liquidity by pulling their quotes and fire off marketable orders and become liquidity demanders. With no restraint on their behavior they have a significant effect on prices and volatility. For the vast majority of firms whose models require them to be flat on the day their day-to-day contribution to liquidity is nothing because they buy as much as they sell. They add liquidity from moment to moment but only when they want to, and they cartwheel from being liquidity suppliers to liquidity demanders as their models rebalance. This sometimes rapid rebalancing sent volatility to unprecedented highs during the financial crisis and contributed to the chaos of the last two years. By definition this kind of trading causes volatility when markets are under stress.

Imagine a stock under stress from sellers such was the case in the fall of 2008. There is a sell imbalance unfolding over some period of time. Any HFT market making firm is being hit repeatedly and ends up long the stock and wants to readjust its position. The firm times its entrance into the market as an aggressive seller and then cancels its bid and starts selling its inventory, exacerbating the stock's decline. Unrestrained by affirmative responsibilities, the firm adjusts its risk model to rebalance as often as it wants and can easily dump its inventory into an already declining market. A HFT market making firm can easily demand as much or more liquidity throughout the day than it supplies. Crucially, its liquidity supply is generally spread over time during the trading day but its liquidity demands are highly concentrated to when its risk models tell it to rebalance. Unfortunately regulators do not know what these risk models are. So in exchange for the short-term liquidity HFT firms provide, and provide only when they are in equilibrium (however they define it), the public pays the price of the volatility they create and the illiquidity they cause while they rebalance. For these firms to say they add liquidity and beg to be left alone because of the good they do is chutzpah.

As with many problems in economics, the problem is one of resolution or the time period over which we analyze behavior. The HFT firms insist they add liquidity and narrow effective spreads and they do at many instants in time during the day. They also take liquidity and widen realized spreads as they rebalance in narrow time slices and in the aggregate they can easily be as disruptive as supportive.

The SEC should require informal market makers to register. Market makers should be subject to affirmative obligations. Market maker intraday positions should be continuously reported to facilitate review. Market makers should have meaningful quoting requirements. The public's order priority at a price should be reinstated and market makers should be forced to yield at a price to all customer orders at that price. Market makers must have standards for exactly when and how they can rebalance their inventory and should be prohibited from demanding liquidity if it accelerates the price trend.

What's Legal - Scienter in the Machine

The complete details of limit order books can be used to predict short term stock price movements. An order book feed like TotalView-ITCH gives you much more information than just price and size such as you get with the consolidated quote. You get order and trade counts and order arrival rates, individual order volumes, and cancellation and replacement activity. You build models to predict whether individual orders contain hidden size. You reverse engineer the precise behavior and outputs of market center matching engines by submitting your own orders, and you vary order type and pore over the details you get back. If you take in order books from several market centers, you compare activity among them and build models around consolidated order book flows. With all of this raw and computed data and the capital to invest in technology, you can predict short term price movements very well, much better and faster than dealers could 10 years ago. Order book data feeds like TotalView-ITCH are the life's blood of the HFT industry because of it and the information advantages of the old dealer market structure are for sale to anyone.

HFT firms point out that they do not have control over the order book and they do not have a first look at customer orders. The predictive power of today's analytic models and the vast amount of data available today have erased this distinction however. A first look at customer orders does not matter if you can use detailed order book feeds and predict incoming orders to any profitable degree of accuracy.

The Release asks whether two HFT strategies are a problem and in what ways they should be regulated. The SEC should define both "momentum ignition" and "order anticipation" strategies as manipulation since they are both manipulative under any plain meaning of the Exchange Act. These strategies identify and take advantage of natural interest for a trader's own profit or stimulate artificial professional interest, also for the trader's own profit. They do so by bidding in front of (raising the price) or offering in front of (depressing the price) slower participants they believe are already in the market or that they can induce into the market. They both depend on causing short term price volatility either to prey on lagging natural interest or on induced professional interest. Any reasonable definition of "manipulation" in the equity markets should explicitly ban them by name.

Imagine a HFT market maker that needs to buy to rebalance. It removes its inside offer, posts multiple offers away from the market to induce other selling interest, and starts buying when that induced interest shows up (hopefully at lower prices). This is a momentum ignition strategy executed by algorithm. What concepts allow for the prosecution of such manipulative algorithms? How many investigations have closed when a firm deadpanned "that's the way the algorithm works" as if manipulation is OK when it is fully automated and scienter cannot be attributed to an individual trader?

Order anticipation is the fully automated version of keeping an eye on Tommy when you know Tommy handles institutional order flow. You relax when Tommy is eating lunch. When Tommy finishes lunch and walks over to a dealer post, you follow and listen in. Today, instead of keeping an eye on Tommy you listen in to TotalView-ITCH and look for hidden orders, or you reverse engineer matching engine behavior and sniff out reserve orders.

As the time and place advantages of professionals on the floor or in dealer-owned networks have been replaced by the time and place advantages of detailed order book feeds and co-located servers and inferential algorithms running on those servers, lawyer-regulators have lost visibility into how and why professionals trade in the market. Floor officials and trader badges have at best been replaced with OATS and OATS-like audit trails but OATS is not up to the task at hand. The SEC should launch line-by-line examinations of the algorithms of the country's HFT firms and find out specifically what data they use and what orders they generate, why, and when. The SEC should also completely revamp market audit trails and identify firms as precisely as possible. Every order-generating algorithm within a firm should also be identified as precisely as possible, and these audit trails must be released to the public so researchers can study the effects of HFT firms. The SEC should also require that all customer orders opt-out of detailed order book feeds because detailed order book feeds are used to the investing public's disadvantage, and so be it if customers are convinced to opt-in.

What's Legal - Speed

HFT took hold as two innovations came into the market. The first innovation was technology, and because of widespread and well-placed disenchantment with intermediated markets and their abuses the second innovation was the pure price/time book. The pure price/time book also convinced regulators to eliminate customer priorities because the thinking was that everyone would compete on a level playing field.

No wonder the race for speed today is unending. Some firms estimate that a millisecond advantage is worth $1 million or more a year in trading profits. That is because of the pure price/time book and because of competition among HFT firms to be first at a price. Being first means you capture the spread but it also means you shoot the (buy-side) elephant, it means you rebalance your inventory before it gets more expensive to rebalance, it means you trade against anyone you spoofed into the market, and it means you arbitrage anyone who is slower or who depends on slower market data feeds than you do.

Beyond the predictive analytics discussed above, just like the old dealers, co-located HFT firms do in fact get a first look at incoming orders because order book feeds are faster than the National Market System. Even market centers do not use consolidated NBBOs in their own trading systems because the order book feeds are faster. In a flat price/time world a millisecond or microsecond is all you need, so if you can predict price direction based on order book details most never see and if you can predict who is likely informed and who is not based on those details, and if you can analyze and respond to incoming order flow before the rest of the world even sees a consolidated quote, you can paw over order flow as profitably as any dealer but without the same regulatory oversight. With nonmarketable orders the fairness problems of this so-called latency arbitrage seem very similar to the fairness problems of flash orders.


With pure price/time priority we have a market structure that offers significant advantages to certain participants. Market centers charge those participants large data and co-location fees to improve their advantage. Those participants are paid to replace regulated intermediaries but are themselves essentially unregulated and there is no meaningful application of anti-manipulation statues even though a strategy can be plainly manipulative, and there is no concept of "scienter in the machine". Market centers have created order book data feeds and provide detailed information about hidden trading interest, and HFT firms use detailed order book feeds to reliably predict short term price movements and to arbitrage the slower National Market System.

As has been the case in the past with intermediated market structures, if suitable data is made available we can be sure future research will show HFT market making firms make money when they demand liquidity, that their liquidity demands are informative about short term price movements, and that they behave more like aggressive, profit-maximizing traders than the simple liquidity suppliers they say they are. Is it any wonder large profits flow to HFT players? Using an admittedly back of the envelope estimate and adjusting for volume and spread size changes, HFT market making was 10 to 20 times more profitable in 2008 than traditional dealer firms were in 2000, before the HFT revolution.

It is no argument to say the advantages of HFT firms are available to anyone. They are not. They are only available to those with the capital and regulatory latitude to pay for those advantages. They are out of reach of retail investors and most institutions in exactly the same sense in which in the old days a seat or dealer license at an exchange was available to anyone (not at all). The corruptible but regulated dealer has been replaced by largely unaccountable and unregulated firms. You should not underestimate the widespread and legitimate anger at these firms. Please regulate them.