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Time To Rethink A Broken Market

Chris Sparrow, an expert on high-frequency trading, tells editor Paul Amery why he believes the current structure of equity markets is fundamentally unfair and needs urgent reform Chris, what’s wrong with the current structure of equity markets?

Sparrow: The current market structure is fundamentally unfair, since different participants have unequal temporal access to information.

To put it simply, if other people can see that your order has been filled before you can, or that there’s been an update to a price quote before you are able to see it, you’ll lose confidence in the market.

This comes down to how price signals are propagated. Currently, no two participants receive price and quote information simultaneously. If you want to ensure fairness in the markets you need to level the playing field for everyone.

If we can fix this then we should be able to restore some confidence to the markets and trading volumes, which have declined dramatically in recent years, should recover. Is the fragmentation of equity market trading between different venues a concern?

Sparrow: I’m not concerned with fragmentation per se, as competition between trading venues is good. What’s missing is synchronisation and coordination.

Let’s take the air travel system as an analogy. Airlines want to minimise fuel use and so all have an incentive to land their planes first. If you allow that, you’re going to have lots of crashes. Regulators impose structure via an air traffic control system, reducing the systemic risk.

Such coordination simply doesn’t exist in the equity markets today and regulators tend to take a passive role, watching what happens and taking action after the event if something goes wrong.

I’m not for overregulation and in my opinion introducing competition between trading venues, which happened in the US under Regulation NMS in 2005 and in Europe following the introduction of MiFID in 2007, was a good thing, as I’ve said. But there have been some unintended consequences of these reforms that now need to be dealt with. Should exchanges be forced to go back to some kind of utility status from their current for-profit model?

Sparrow: I don’t think that’s necessary. I think the for-profit exchange model can continue to exist, but subject to a requirement for synchronisation.

Here’s another example. Let’s say I buy a solar panel and want to contribute electricity back to the grid. If I want to do that I have to supply the electricity at 60 Hz. I can’t unilaterally decide that I want to give the electricity back at 45 Hz.

There’s an infrastructure requirement that should be based on a policy of coordination. If I want to build an ATS (automated trading system) and plug it into the rest of the market grid I should have to do so in a standardised way. Otherwise the system will generate a huge amount of quote “noise” and introduce exploitable latencies that act to inhibit fair trading. What led you to identify the current trading system as a problem?

Sparrow: I’ve done a lot of work in transaction cost analysis (TCA). I was looking at a particular order and for purposes of comparison wanted a proxy for the Canadian equity market. For this I used the iShares S&P/TSX 60 ETF (TSE: XIU).

It turned out that there were a million quote updates in this ETF during a single trading day of 23,400 seconds. Why do we need so many updates? They impose significant storage requirements on everyone, take up significant network bandwidth and arguably do not contribute significantly to price discovery.

All the trading data that’s being produced is an externality on the whole market. We all have to buy bigger hard drives, bigger servers and network switches just to process the data, even though there’s little extra benefit in doing so.


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