We read the transcript of the excellent speech delivered to the International Paris-Europlace Financial Forum in Tokyo on November 29^th, 2010 by Mr. Kiyohiko G. Nishimura, Deputy Governor of the Bank of Japan. We encourage you to do the same; it is available here, and it is a concise read. We hope the good Deputy Governor pardons our summary right now, and that he, and those regulators in Japan who are examining how to deal with new high-speed market microstructures from a capital-formation-and-fairness regulatory perspective, allow us to offer some advice and perspective from a small brokerage firm in New Jersey.

Summary of Mr. Nishimura’s Speech

1)       Electronic Trading is about 70% of the currency and equity trading in the US, 50% in Europe, and an estimated 20-30% in Japan, where it is on the rise.

2)       MTF’s have a small market share in Japan, but it is increasing (i.e. fragmentation is not yet the issue that it is in the US).

3)       HFT technology has benefitted many types of investors, as algos are used to shred down large orders into thousands of smaller ones, and therefore minimize market impact. In the US this has reduced market-making costs and bid-offer spreads.

4)       This algo shredding of institutional orders, and HFT, together have “lessened intraday volatility and it stabilizes markets under normal circumstances most of the time.”

5)       The high speed trading is also positive because it enables faster arbitrage, and so it boosts efficiency and is likely to “boost the efficiency of the allocation of scarce resources.”

6)       However, HFT may introduce market vulnerability.

7)       HFT also introduces new ways to manipulate markets, which are very, very difficult to detect.

8)       Relying on HFT as “liquidity providers” is problematic in stressed markets.

9)       Hence, Market Diversity is very important!

Mr. Nishimura’s speech is well-balanced, concise, lucid, and very well written. We feel bad even offering any criticism of his words, although we do so below.

Our Comments on Mr. Nishimura’s Speech

1)       In the US we are very accustomed to having the narrowing of spreads tossed around over and over as a benefit of HFT. This in our view is a nonsensical argument. Spreads meant something when markets were quote driven, and not order driven. When MLCO quoted a market in stock ABCD at 25.50 by 25.55 1,000 shares up, and executed customer orders against this quote for no fee (i.e. no commission), the concept of a spread meant something. In current order-driven markets, where commissions are paid by investors, and the velocity of quote changes is great, the notion of a spread means little.  Think of it this way: if you bought 1,000 shares at 25.54 when the market was 25.54 by 25.55 did you save money? Did you save a penny by not paying the offer? 25.55 is an arbitrary number. You can just as validly state that you saved 20 cents by not executing at 25.74. And you can also say that you lost 20 cents because you paid 25.54 instead 25.34. You paid 25.54 because that is what you wanted to pay. It is an order driven market. There is no real market making going on.

2)       High Speed Trading does in fact quickly make efficient the security pricing among different liquidity pools and exchanges. The question though is why are there so many liquidity pools and exchanges? Is all the fragmentation good? Is there a point where fragmentation not only has diminishing marginal returns, but actually outright negative returns and risks?

3)       HFT that “lessens intraday volatility and stabilizes markets under normal circumstances most of the time” may be accurate in the most liquid large-cap names, where most investors never felt they needed their HFT to begin with. Moving down the market-cap scale, investors are far more likely to find a predatory style of HFT that is much less about rebate arbitrage and much more about footstep detection, front-running, and volatility creation.

4)       Who is behind the fragmenting? What is in it for them? In the US there is a perception, certainly shared by us, that For-Profit Exchanges and ATS’s are no longer neutral referees who provide platforms for capital exchange and facilitation for all equally. They know that the highest volumes and profits are generated by hyper-short-term HFT hot-potato trading, and they cater to them as such. If HFT firms find that they need some new facet, nuance, or variable introduced that will enhance their ability to make money hyper-trading (at the expense of slower traders and investors), you can count on the Exchanges and ATS’s to deliver that variable. They will do this whether it is good for the markets or not. They will do this even if they feel that the variable is wrong. Witness flash and step-up orders in the US, as well as the whole concept of enriched data feeds, with the sensitive information they provide.

5)       Relying on HFT in bad times by increased incentives (carrot) or by increased obligations (stick) will not work. First of all, any incentive will never make up for losses that would be incurred by forcing any participant to stand in front of a train. Likewise, any fine will pale in comparison to those losses. Secondly, mandating certain quote bands will be meaningless. The most co-located HFT prop firms will be able to cancel any bid or offer before it interacts with a contra-side anyway. They have the tools and strategies to do just that.

6)       Regarding Mr. Nishimura’s statement that diversity in market participants is crucial, we applaud him for his sage perspective and wisdom. That diversity is crucial! We at Themis have actually addressed this very same point to regulators and in the press. Our markets are like oceans. For them to be in balance and in equilibrium (stable) they need all kinds of players (species). HFT is in fact the evolution of many types of short term trading. It has been so efficient that it has driven many species into extinction. As such, while we ideally want a market with numerous participants with holding periods that are measured in sub seconds, in seconds, in minutes, in hours, in days, in weeks, in months, and in years, we instead now have a barbell structure which has players whose holding periods are perhaps months or longer on one end of the spectrum, and seconds on the other end of the spectrum, The middle has been driven out. That middle would have helped on May 6^th.

Our Advice:

Toothpaste cannot be put back into the tube once it is squeezed out! The genie cannot go back into the lamp. Accordingly, step wisely from the outset, and consider these observations.

1)       It is to the Exchanges’ benefit to fragment as much as possible; not Investors.

2)       Lobbyists will pervert rules to a highly concentrated and greedy select few. Stop them.

3)       Rebate/taker pricing models encourage volume, which is different from liquidity.

4)       Don’t take the bait thrown by those earning billions from HFT; creating a common-sense fair highway for all will not kill liquidity. You may see volume decline in your 100 largest stocks, but remember volume is not the same as liquidity. Do two firms trading a single share one million times back and forth during a day equal one million shares of liquidity?

5)       Markets are a highway needed by all. Is it best served by being maintained by a few private and staked interests? (i.e. colocation revenue)

6)       Watch conflicts of interest from cross-ownership. Should HFT’s own Exchanges who make rules and new arbitrage-fragmentation opportunities for HFT’s?

7)       Pay attention to the data feeds being provided or sold by Exchanges and ATS’s. Why do they need to have more information than

1. Quantity
2. Price
3. Time
4. Location where traded

8)       Should Exchanges be essentially selling instant replays of all cancellations, orders, revisions etc. by all participants that aid in hyper short term trading? Why do they do this? Because hyper-short term HFT trading requires speed advantages that the Exchanges are happy to sell (i.e. colocation revenue).

9)       Create fiduciary standards that all market participants with customers must adhere to (i.e. Do not allow an Exchange to place one set of its customers above another. While that argument may be fair in selling widgets, it is toxic to financial superhighways needed for trust and capital formation).

Unfortunately, with the large technology outlays and investments made by so many firms, once a course is embarked up in our market structure, it is very hard to alter. Trust  us Yankees. We know.