By David Coolegem, Thomas Hall and Ian Berriman, financial services experts
Much has been written about Italy’s decision to tax high frequency trading. Strictly speaking, however, the new tax is not on HFT per se, but on traders cancelling or amending orders shortly after (0.5s) submitting them. The tax therefore aims to rid the market of controversial practices such as quote stuffing – which traders use to cloud other traders’ understanding of market liquidity or to manipulate the market using phantom liquidity.
While the Italian tax aims to stamp out all such trading strategies, it does make exemption for market makers. As market makers are presumed to be acting as intermediaries in the market, they are thought less likely to be involved in the more controversial of HFT strategies. This is not necessarily true. Some market makers have been known to engage in HFT wash trade strategies. In addition, as most HFT activity appears similar to market making, it wouldn’t be difficult (or surprising) if many of the larger HFT players start applying for formal market maker status in the future.
Following the Italian’s lead, other exchanges will be looking for a way to balance their exchanges without allowing exemptions. Creating a level playing-field for all market participants is one option, but this has its own complications. So what should they do instead?
A realistic approach to prevent harmful HFT practices would be to change the dynamics of the market so that pure speed, in itself, is no longer the strategic advantage that it was. Introducing minimum resting times and intra-day auctions are the two most viable options here.
Minimum resting times
One way to achieve a balanced market would be to simply require a minimum resting time for every order or quote placed on an exchange. This could be set at a level that would leverage a balance between market speed and efficiency.
Another idea that is gaining traction – albeit a more radical one – is the concept of splicing the trading day up into multiple auctions, each of which takes place every 0.5s or so. While this would fully eliminate the ability to cancel orders in the auction period, meaning HFT strategies would need to change, there would still be some arbitrage advantages for those able to know the auction results first, or put their quotes in last.
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