Germany's HFT Ban – Be Careful What You Wish For

The financial press and alternative investing blogosphere is all abuzz about proposed German controls that attack High Frequency Trading (  Government always justifies its coercive intrusion into markets by appeal to a sense of the "public good", and its interference never delivers the goodies as advertises (see my doctoral dissertation for a full explanation of this:  A Free Market for Goods, Services, and Money).

In this article, I focus on just one aspect of this new control.  They are proposing to set a cap on the ratio of orders to trades.  At first, this sounds reasonable.  "Why should anyone have 10,000 orders for every trade that executes??" This is an appeal to emotion, to make the reader angry at the thought that this is somehow cheating or unfair.


Let's take a look at a shadowy and poorly understood player: the market maker.  He first appeared in the London coffee houses where stocks were traded. Sellers lined up on one side, in ascending order of price (so the best offer (ask) was at one end). Buyers lined up on another side, in descending order of price (so the best bid was across from the best offer).

The market maker came in and said he was ready to buy or sell.  He quoted a bid that was higher than the best bid and an offer that was lower than the best offer.  Virtually everyone was outraged, and many thought this newcomer must be some kind of criminal or cheater. They were wrong.  Their outrage was fueled because the best bid was topped and the best offer was undercut.  How unfair!

The market maker earns his profits by narrowing the bid ask spread.  Today, of course, most people understand this and there are market makers in every liquid market.  What they often don't understand (judging from the strident tone on many alternative investing blogs) is how he operates. Liquidity does not mean a willingness to buy from all sellers and prop up the price.  Let's not confuse market making with central banking!

It is not the market maker's job to bankrupt himself by buying in front of an avalanche of sellers.  When the avalanche does occur, and the market maker smartly steps aside, the ensuing crash should not be blamed on him. It should be blamed on the economic climate, the bust phase of the credit cycle, monetary policy (especially falling interest rates), and the liquidity crunches that occur due to the rising burden of debt.

The market maker is working to narrow a simple spread: the difference between the bid and the ask.  As the bid from buyers moves or the ask from sellers moves, the market maker must adjust his bid and ask.  The rate at which he must do this depends on the rate at which others in the market are changing their prices.

Another point worth highlighting is that sometimes a market is slow.  The bids and asks move up and down, but one can observe no trade for an hour or more.  I have observed this more than once in options on copper futures.  In the morning, I execute a trade.  The "last" price immediately updates on my eSignal screen to show this price.  By the afternoon, the bid and the offer could be a mile away from the morning.  And yet my trade still shows as the "last".

So what will happen if the regulators force market makers not to change their prices more than twice a second, or force them to limit the number of orders based on the number of trades?

Some market makers will be rendered submarginal, and they leave the market entirely.  The survivors will be forced to widen their quoted bid-ask spread enough to cover the risk of a price movement during a time when they are barred from changing their prices.

The net result will be wider bid-ask spreads. Both producers and consumers will experience this as higher cost, and traders will experience this as higher volatility. Some traders will profit from this, and the real economy will have to absorb another blow.

Be careful what you wish for!


Keith Weiner is a technology entrepreneur and president of the Gold Standard Institute USA.

He was the founder of DiamondWare, a Voice Over Internet Protocol software company, which he sold to Nortel in 2008. He is an Objectivist who has his PhD from the New Austrian School of Economics, with a focus on monetary science.

Keith, who currently trades and analyzes precious metals and commodities, advocates a return to a proper gold standard and laissez-faire capitalism. He lives with his wife near Phoenix, Arizona.




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7 Responses to “Germany’s HFT Ban – Be Careful What You Wish For”

  • AndrewBissell:

    As an HFT market maker (and an Objectivist), this article warms my heart. :-)

    One of the most puzzling aspects of HFT criticism to me is this idea that market makers stepping aside during periods of severe market stress is somehow new and unique to HFT. Any decent history of the 1929 crash makes mention of the fact that numerous stocks went “no bid” despite the presence of NYSE specialists with a supposed obligation to maintain an orderly market.

    I think Chris Stucchio’s blog has some of the best discussion of HFT around:

  • Floyd:

    The market should have same rules for everybody.
    This market is not truly free!
    It is not as a regular trader unhappy with HFT favoritism can go to another exchange.

    It is rumored that HFT gets information *under the table* via undocumented APIs.

    It is rumored that HFT gets some monetary incentive for its trades, an incentive not available to other exchange customers.

    HFT flooding the exchange with gigantic number of non-executed requests externalizes costs.
    These non-executed trades still load the exchange with real costs.
    Somebody pays for that. At this point it is the regular traders.
    Now, if the non-HFT customers could go to another exchange then the free-market would take care of this issue. However, there is no other market to go to…

    Finally, there is the issue of proximity.
    Being closer to the data core is an advantage.
    Again, in a truly free market, non-HFT customers would have the option of going to an HFT free exchange…

    Yes, I realize that the HFT and non-HFT exchanges would be interconnected, but the non-HFT exchange could guarantee the HFTs have no advantage over non-HFTs (when it comes to pricing, undocumented APIs, etc.).

  • mc:

    The issue I have with HFT is not the market making aspects, but the ability to create an order and cancel it for the express purpose of discovering the limit price and quantity of an order to be filled. This is supposed to be hidden information, but due to a loophole in the order process, the HFT systems can exploit the surplus between your limit price and the actual market. No extra liquidity is delivered in the process, and, in fact, it maximizes “slippage” between the equilibrium price and the realized actual price. The result is that buyers and sellers execute trades as near as possible to their limit price instead of the ideal.

    There are rules to prevent your broker from ‘front-running’ your trades, yet this allows someone else to accomplish the same thing and it should be stopped.

    • mc:

      That said, Keith is right that this exact regulation will result in wider bid-ask spreads. There are more subtle ways of removing the price-discovery failures of HFT while still allowing the liquidity/market making value of HFT to exist. The purpose of a vast majority of HFT trades is to glean information from the slower traders to maximize the spread for arbitrage purposes. That should be the measure, whether liquidity increases and bid-ask narrows, instead of the arbitrary ratio of orders to executed trades. In fact, this number could be easily gamed, with a rapid pair of buy/sell orders with tiny volume on the most liquid security executed just to keep the ratio below 10000.

  • xcut:

    I’m not buying into this. Market makers were around long before HFT was.

    I’m sitting in the thick of this, and I can tell you that there is no fair market in high frequency trading. This is not about coming up with the best trading algorithm and and executing. It’s about who is cosiest with the board of the exchange and gets to put their machines physically closer to the core.

    I see no interference in the market if a maximum bid number is set per second. It will work just fine if all participants are set the same rules. At the moment, they are not!

    And, by the by, worrying about increased volatility if HFT is eliminated seems strange; the jury is out whether HFT itself increases volatility. A lot of people seem to think it does, at least in times of high uncertainty when the algorithms start misbehaving.

    • Keith Weiner:

      As with all laws, for example, the minimum wage law, there is no effect unless the limit is set below what the market demands.

      If the bid on unskilled labor is $30 per hour, then a minimum wage set by fiat at $10 per hour will do no harm. Of course, at this level there will be demands to raise it to $35. At $35, the law will push a big subset of the working population under the margin. They will not be employable.

      It is the same with a diktat that forces market makers to hold their bids for a minimum period of time. It will have no effect unless the minimum is larger than the time they need to change it. Think about this!

      You want to force someone to hold a bid to spend his own money on a security when he needs to withdraw it!

      Aside from the force, which is morally unjustifiable, think of the unintended consequences of this, man! As Austrian Schoolers, we pride ourselves on being the school which can dissect the mainstream to see the unintended consequences, right?

      Do you think you can force someone to buy something he does not want to buy? What distortions and “unintended” consequences do you think could arise if you try?

      By the way, I want to say two things about the unfair advantage that some market makers are alleged to have over others. First, is it possible that this is actually the unintended consequence of some other regulation, elsewhere?

      Second, is the point of banning HFT to improve the market–i.e. for investors and issuers? Or is it to equalize the best players down to the level of the mediocre?

      • sandorgb:

        Keith, I enjoy your pieces. However, I tend to think you have rose-colored glasses when it comes to the ideal of a free market. In theory, it’s a beautiful thing. In practice, you have cartels, mafias, raping and pillaging, slavery and exploitation. Does regulation and government solve this problem? No, not really. But it does introduce curbs. Would it be better in a regulation-free world where everyone can carry around an assault rifle? I’m an anarchist philosophically, but I don’t pretend that laissez-faire with the current crop of humans is workable or even desirable. If it were, we’d be there. One day perhaps humans will mature and become responsible, respectful and self-disciplined and all nation-states will wither away. That’s my long-long-term forecast.

        As for HFT, I’m a trader, so I appreciate your argument. It always comes down to costs and who will bear them. The exchanges need to make money, so they offer co-location. If you tax cancellations or cap them, you will get wider spreads. The internet has flattened trading costs considerably and we have a surfeit of theoretical liquidity. However, if most ‘market-makers’ step aside in extreme conditions, and most HFT algos chase the same move, HFTs can, in theory, increase volatility in the short term, especially in far-from-normal conditions when ‘common sense’ does not enter into the equation. This is the reason for daily price limits in markets, and so-called ‘circuit breakers’ in the equity markets. HFT programs are the logical outcome of electronic trading. The system is only as good as the coding. There will be errors, and there will be moments when liquidity seems to magically vanish. It was like this before computers ever came on the scene. The dynamics have not changed. The markets are a predatory game, much like poker. Without rules and enforcement, there is always the possibility that someone may pull a gun on you and take your money. So then only people with guns and posses can even play the game. That’s laissez-faire in a world of predators — all players armed to the teeth with hired guns. Even with rules, you have MF Globals, theft, fraud, and as we know, regulations tend to lull people into complacency. Due diligence slides.

        It’s invigorating living on the edge all the time — liberty requires pure vigilance; but most people prefer to be told what to do, trading freedom for the soft pillow of social security. People consistently overpay for insurance to reduce anxiety. Your Austrian theory is not going to change most people’s irrational preferences. Reason is the wrong tool in this case.

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