By: Sean Hendelman and Brandon Rowley
The mechanics of the equity markets are under constant evolution with the consistent goals over time of increasing speed of execution and advancing price discovery. Participants in the stock market have benefited from increased competition among exchanges and brokerage houses that has worked to greatly reduce commission costs and drastically cut execution latency. But, the major changes seen in the last decade have not come without drawbacks. The prevalence of disingenuous quoting on the visible book is extremely high and we propose an order cancellation tax to remedy this detriment to the financial markets.
Recently, there has been a great deal of talk in Congress about instituting a tax on transactions, the so-called “trader tax”. The goal is to raise needed revenue for the federal government and to force Wall Street to pay for the losses incurred by the federal government in supporting systemically important financial institutions. Yet, there is clearly a problem in that a large portion of the tax will fall on everyday investors as transaction costs rise for mutual funds and pension funds holding the bulk of Main Street’s savings. The transaction tax idea, while impacting Wall Street to some degree, has massive collateral damage by raising costs on retail investors. We are not necessarily advocating increasing taxes rather we are operating under the assumption that the government needs to raise revenue and wants to do it by taxing Wall Street. To that end, there is a more effective alternative to the “trader tax” that also has the positive externality of greater price transparency.
While most retail investors probably have little concept of what high frequency trading is or its impacts, active equity traders have seen its pronounced imprint on the markets. High frequency trading is an entirely legitimate strategy of using computer algorithms to execute trading strategies with ultra-low latency. Yet, the explosion in HFT has led to a major structural flaw in equity markets. This flaw is the abuse of uncharged bidding and offering for shares. Level II traders know exactly what this is as they see it day after day in every stock they trade. The book of bids and offers is supposed to be a top-to-bottom list of the prices every player in the market is willing to buy and sell a stock. In this idealized world, there is price transparency as everyone can see who wants to buy and who wants to sell should the participant chose to place a limit order. The price at any given second then is an accurate reflection of the current supply and demand for shares (ignoring the use of dark pools, hidden orders, etc.). Limit orders are meant to be the showing of an explicit intention to buy or sell shares at a predetermined price. Should a trader not want to show his hand, he can execute market orders or use reserve orders. Yet, the book no longer acts in accordance with the idealized world.
Every single listed stock’s order book is filled with false bids and false offers. These limit orders are constantly used to manipulate prices back and forth to the HFT’s advantage. Nearly every higher volume, lower priced stock has a book that is stacked with offers and bids at nearly every penny increment but the vast majority of these quotes are fake. The HFTs submitting the bulk of these orders do not have the objective of being filled on their orders. The purpose is to manipulate the price in some way. This is clearly a deceptive practice occurring in nearly every stock in the current hybrid and fully electronic markets. The high frequency trader has the explicit goal of tricking other traders into believing there is something real there when there is not. Bidding and offering without the intention of actually filling the order is nothing more than a mechanism to mislead other traders. This game, as played by HFTs, is an obscenely inefficient allocation of resources.
After a quick study with our internal systems, we recorded data on the Nasdaq book for Thursday, February 18, 2010. Volume executed off the visible book was 1.247 billion shares (excludes special block prints, hidden liquidity, opening/closing crossing, etc.). Throughout the day, the Nasdaq book showed a total bidded and offered volume of 89.704 billion shares. That means bids and offers in the amount of 88.457 billion shares were put on the book and subsequently cancelled without being filled. These statistics show that only 1% of the total visible order volume is actually executed. Put another way, 99% of the bids and offers placed on the book go unfilled for one reason or another. We would argue that the largest share of this volume can be attributed to HFT stacking the book to move stock prices for their advantage. This is nothing more than trickery and falls outside the spirit of the laws.
Now, it would be far too extreme to ban order cancellation on the whole. Traders and investors need the ability to cancel orders should they change their mind and part of the 99% is precisely that. The flexibility should not be hindered but there should exist a disincentive for cancelling orders because of the obvious current abuse. Even a very marginal tax would significantly curtail the activity while only hardly impacting Main Street. In a world where taxes must be raised and Wall Street should be taxed for bailout funds, a tax on order cancellations is a clear choice.
Taxing order cancellation has various advantages and limited disadvantages. HFT has many valid strategies primarily based on the speed of execution and, in general, it has benefited the market in terms of price discovery. But, the use of intentional trickery to manipulate prices falls well outside the spirit of current regulation. There is no need to enter and cancel hundreds of millions of orders a day unless the HFT is profiting from the results. In order to curb the deception practiced by HFTs, taxing the cancellation of orders will work to reduce it. The goal is not to eliminate cancellations but to make the cost prohibitive to HFTs entering and cancelling millions of quotes every single day. A key positive externality in reducing order cancellations is the increase of price transparency in the markets. The goal of any market is that the price is accurately reflective of the current supply and demand. The tax will also fall largely on Wall Street firms practicing HFT. Retail investors will be charged for cancelling limit orders but the impact will be negligible contrasted with the impact a general tax on all transactions would have. The government will raise revenue, primarily tax Wall Street without hurting average investors and advance price transparency by enacting an order cancellation tax.
Sean Hendelman is CEO of T3Live and heads the automated/high frequency trading division. Brandon Rowley is an equity trader with T3Live.
