The Exchange-Driven HFT Backlash

A backlash has begun against high-frequency traders. Surprisingly, this negative reaction is not from overzealous regulators or naive politicians looking for a scapegoat for the financial crisis. It is the exchanges and electronic communications networks (ECNs) themselves who are spearheading the anti-HFT initiative. Although this attempt to rein in and control the free operation of the marketplace is done by fees, not the heavy hand of government, the negative effects can be far-reaching and could potentially damage the integrity of the market itself.

Both the Nasdaq OMX and Direct Edge plan to start charging traders and trading firms who quote excessively. Starting on June 1, Nasdaq traders will be permitted to post no more than 100 messages for each trade they execute free of charge. For every order posted over 100 that does not execute, the trader will be penalized on the following sliding scale:

  • 0 – 0.2% away from the national best bid and offer (NBBO) receives a weight of 0.
  • 0.2 – 1% away from the NBBO receives a weight of 1.
  • 1 – 2% away from the NBBO receives a weight of 2.
  • 2% or more away from the NBBO is given a weight of 3.

This means that a displayed limit order 2.5% away from the NBBO will actually count as three orders against the maximum ratio. The fee structure works out this way:

  • 100:1 or better: no fee
  • 101:1 – 999:1: $.005 per order
  • 1000+:1 $.01 per order

Direct Edge has a similar proposal that was scheduled to launch May 1 on its EDGX and EDGA platforms. This proposal, called the Message Efficiency Incentive Program, or MEIP, reduces the rebates received by $0.0001 per share if the message-to-trade ratio exceeds 100:1. Direct Edge will also provide additional incentives to liquidity providers that “contribute to price discovery with more static quotes,” according to The Trade News. However, Direct Edge has decided to delay the launch of the new program until June 1 to allow members to get ready and coordinate with Nasdaq.

This is the third initiative by Nasdaq in the past 14 months to restrict so-called “excessive quoting” away from the inside market. The Investor Support Program, put into action in 2010, rewards firms with a higher rebate if they hold to a message-to-execution ratio of 10:1. The PSX recently started a program requiring orders to rest on its books for a minimum of 100 milliseconds. This effort is designed to discourage HFT shops from constantly placing and then immediately canceling orders on an exchange designed for block trading.

The question is: Are these new fees and programs good for the market overall or simply another way for the exchanges to reduce technology costs, thus creating a source of easy revenue? Interestingly, not so long ago, the exchanges were very much opposed to instituting penalties for the traders who quoted the most, because they provide crucial liquidity. This reversal of opinion makes it appear that the exchanges are simply looking to increase revenue during the current period of low volume, no matter the cost. Unfortunately, the exchanges are targeting the wrong source to ramp up their revenue. The fee structure and rebate deletion may easily result in less liquidity and volume as HFT shops react by pulling out of the market. The exchanges and ECNs are throwing the baby out with the bath water with these knee-jerk proposals.

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