High Frequency Trading (“HFT”). Firstly, what is it?
HFT is as far as possible from your archetypal perception of Wall Street traders bellowing profanity over the phone as they execute trades. HFT is a subset of algorithmic trading, which essentially makes use of complex algorithms which collect and dissect a plethora of financial data and thereafter, execute trades, all within the space of milliseconds. HFT typically entails holding stocks for immensely minute time periods, attempting to capitalize on small amounts of profit on every trade. HFT is completely anonymous, operating entirely independently of all human interaction (once correctly coded, of course) and having considered all the possible available data in the market.
The United States Securities and Exchange Commission(“SEC”) attributed the following five following characteristics to proprietary HFT firms:
(1) “the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders;
(2) the use of co-location services and individual data feeds offered by exchanges and others to minimize network and other types of latencies; (3) very short timeframes for establishing and liquidating positions;
(4) the submission of numerous orders that are cancelled shortly after submission; and
(5) ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions over-night)”
The European Union has its own definition for HFT, stated in the Markets in Financial Instruments Directive II (“MiFID II”), however this will not be discoursed further as much of the subject matter extends beyond the scope of this article.
HFT is an immensely specialized field and this article does not aim to traverse the intricacies of HTF in great detail, but rather wishes to introduce the possibility of incongruency between this highly advanced technology and South Africa’s own financial legislation. Only select stratagem and methodology forming part of HFT will be referred to so as to demonstrate the disparity between this integral sector of finance and the law.
HFT trading on a stock exchange is not only common, but is in fact the dominant method, accounting for 45% of global stock market trading as of 2013. In South Africa, HFT accounted for almost 35% of the equity trading on the JSE in 2017. In 2018, roughly R6.4 trillion worth of stocks were traded on the Johannesburg Stock Exchange (“JSE”). This means that approximately R2.25 trillion worth of trades on the JSE occur through HFT, and this same value of trades may be happening in contravention of the prevailing legislation.
This article will focus on HFT using the arbitrage strategies, which relate to incongruencies in pricing. One such strategy is the cross-listed arbitrage, which concerns stocks listed on multiple exchanges, by capitalizing on the price discrepancy between any two markets at a given time. Such discrepancies only endure for nanoseconds, and so could only be exploited by HFT.
Another form of arbitrage strategy is latency arbitrage. Central to this strategy is the latency (lag) between a market participant purchasing a stock and the actual execution of the trade. HTF would therefore be able to profit off of this latency by either selling their stocks (having become aware of an incoming increase in supply of said stock, which may lower the price of the stock) or purchasing the stock (in anticipation of a participant purchasing a large portion of the stock, which may increase the price of the stock). This form of trading has resulted in a practice known as co-location, whereby HTF firms place their trading facilities as close to the relevant stock exchange’s servers as possible, thus receiving market related information milliseconds before their competitors. To gain some perspective, it has been estimated by a major brokerage firm that a mere one millisecond advantage may be worth $100 million a year.
Another subset of HFT is manipulative strategies, such as quote stuffing, whereby an extremely large amount of orders is placed to the market and subsequently cancelled in order to confuse other traders. This is an artificial manipulation of the market, something not prohibited in stock trading.
BENEFITS OF HFT
HFT results in an increase in market efficiency as it occurs having considered all available data and removes the uneconomical human element. There is also an increase in liquidity, which is defined at the ease with which an asset can be converted into cash without affecting the price of the said asset. It is a positive as it encourages market participant involvement in the stock exchange. Naturally, HFT dramatically increases the amount of trades occurring and so liquidity thus increases. HFT also lowers transactional costs involved, due to the sheer volume of trading it allows for, all with minimal human intervention. HFT allows for continual trading completely independent of human involvement.
REGULATION OF HIGH FREQUENCY TRADING IN SOUTH AFRICA
The chief legislation is the Financial Markets Act 19 of 2012(“FMA”), which repealed the Securities Services Act 36 of 2004. In terms of this Act, the Financial Services Board(“FSB”), empowered by the Financial Services Board Act 97 of 1990, as the principal regulatory authority for governing “Chapter 10 – Market Abuse” of the FMA. The FSB has additionally formed the Directorate of Market Abuse (“DMA”) as well as the Enforcement Committee(“EC”). These entities serve as an investigative unit and enforce market abuse liability respectively.
The JSE itself, however, is responsible for its own regulation and is primarily regulated by its Surveillance Division (“SD”). This division is responsible for detecting any market abuses and reporting same to the DMA. The DMA then investigates the alleged transgressions and thereafter refers the matter to the EC for the enforcement of penalties.
The FMA makes provision for the possibility of the introduction of a binding code of conduct which may be imposed upon any class of market participants in order to advance the objectives of the FMA. A possible use of the code of conduct is to provide for “any other matter which is necessary or expedient to be regulated in a code of conduct for the achievement of the objects of this Act.”
In relation to prohibited trading practices, described in section 81, the FMA states that no individual may knowingly directly or indirectly participate in any practice which is likely to create a deceptive appearance of the demand for, supply of, or trading activity related to, security. In addition, the FMA states:without limiting the generality of subsection (1), the following are contraventions of subsection (1):
(a) Approving or entering on a regulated market an order to buy or sell a security listed on that market which involves no change in the beneficial ownership of that security, with the intention of creating –
(i) A false or deceptive appearance of the trading activity in; or
(ii) An artificial market price for that security;
(b) Approving or entering on a regulated market an order to buy or sell a security listed on that market with the knowledge that an opposite order or orders at substantially the same price, have been or will be entered by or for the same or different persons with the intention of creating –
(i) A false or deceptive appearance of the trading activity in; or
(ii) An artificial market price for that security…”
It is no doubt clear that the thought of attempting to police a concept of this nature is a daunting task for law-makers, however the legal jurisprudence is notoriously slow to adapt to the constant barrage of technological advancement and HFT is no different. This segment of the finance field is highly technical in nature and so as a result, is almost untouched by any legislation precise enough to have a genuine regulatory effect.
Specific provision is not made for manipulative HFT stratagem in the FMA, however these stratagems cannot be reconciled with the FMA and fall squarely in contravention of the primary stock trading legislation. The latency arbitrage strategy by definition entails taking advantage of information that is not yet known by the rest of the market. Quote-stuffing, similarly, principally aims to confuse other traders by artificial manipulation of the market price. It is clear that re-alignment of HFT with the legislation is required in order to maintain market confidence as well as halt potentially trillions of Rands of unregulated trades occurring on the JSE.
Additionally, there are numerous issues that result from the failure to regulate HFT. Potential regulators either lack either the requisite expertise or funding to be able to adequately police HFT and the number of transactions occurring. The sheer volume of trades executed through HFT results in any intention to recreate a portion of trading activity on any given day becoming an immensely costly activity for potential regulators. Standard legal processes such as discovery would also become unfeasible because of the amount of data involved. There is the additional difficulty of having to monitor trades between different exchanges in various countries. HFT’s autonomic capability may result in difficulty in establishing elements of the contravention of an offense, such as intention.
Regulation for this sector of commerce is essential as in the absence of adequate regulation, confidence in the financial markets may decrease as participants doubt whether the prices of stocks are indeed accurate, HFT methods being aimed at manipulating prices.
HFT is undoubtedly a natural technological advance within the field of finance. It allows for a near infinite increase in the quantity of trades, as well as improving efficiency and reducing costs of trading in the long term. However, such a powerful trading tool requires stringent and precise regulation that is tailored to it. As it stands, the South African legal sphere falls short of any adequate legislative instrument that may serve as a parameter within which HFT may occur. As a result, much of the stock exchanges that occur through HFT are currently in contravention of the FMA. With regard to any possible intervention, there is the fiscal objective of maximizing profit, while there is the contrasting consideration of the legislature intending to ensure fair and transparent commercial practices. This is the problem which lies at the foot of the legislature. Whichever notion does eventually prevail, it is clear that for South Africa to remain at the forefront of the global stock market, HFT necessitates substantial alteration to the FMA and the peripheral legislation.
Written by Loyiso Bavuma Checked by Caitlin Wilde