Penalties for high "order to trade" ratio will spur smarter algorhytms

Italian Borsa Move May Breed Brave New World of Algos

by John Bates, Chief Technology Officer, Progress Software

The Italian stock exchange Borsa Italiana's decision to clamp down on "excessive" HFT orders is likely to be a shot heard around the world. The Borsa is considering charging HFT firms for sending too many orders, particularly ones that do not result in trades, according to the FT.

Order-to-trade ratios have long been a concern of exchanges, ECNs and other trading venues as quote volumes go through the roof. If the number of orders being sent greatly outweighs the number of trades concluded, this can cause problems. All unnecessary orders (i.e. cancellations) create a load on exchanges; and they can provide a smokescreen to hide potentially abusive behavior (so called "quote stuffing").

I am willing to bet that the Borsa's move will be followed elsewhere. Most exchanges and alternative venues express concern that they will not be able to cope with the amount of orders coming down the pipe if they continue to grow. The SEC is considering charging HFT firms for cancelled trades, according to The Wall Street Journal. And interconnectivity between exchanges is increasing, so in order to trade smoothly between exchanges and effect arbitrage it is important that all destinations follow similar rules and procedures.

But many exchanges and ECNs, particularly in the U.S., have policies to encourage HFT rather than discourage. (Some venues even offer a tidy sum to attract large trades and liquidity providers by offering volume rebates.) The Borsa solution is the opposite of this -- it will discourage HFTs from experimentation.

But HFT players argue that it is necessary to dip their toes into the waters of the markets before they dive in and execute their trades. Their algorithms can dart in, test depth of book and trader/market sentiment, and swoop out -- often without doing any business.

The question here is, do you need to send out orders to test the market? What if you could watch and then act? Using trade orders is akin to being a venus fly trap, with your tentacles out waiting to catch the odd unwary fly. What if you could be more like an alert frog, waiting until you see the prey and then sticking your tongue out to catch the right one -- or lots of them?

Testing the waters with quotes is probably the most harmless issue in HFT. Other issues include quote stuffing, where HFTs "stuff" the book on a particular share with millions of orders, so that others cannot get in to trade. This is a kind of front-running, where the quote stuffer gets the deal done before the market can move on him.

On balance, I think the Borsa has the right idea. The Borsa benefits by having a more bulletproof trading platform, less sensitive to quote stuffing and errors. "Real" players are rewarded with real liquidity and done deals, while those who may have a more hidden agenda are discouraged from quoting.

I wonder if this is a brave new world for algorithms, where they have to pay a penalty for high frequency strategies. If so, they will have to change. The Borsa's solution, especially if it is embraced by other trading destinations, may spawn a new generation of intelligent "sensing" algos.

Today's algos that are using techniques to flood the market will be replaced by smarter ones that are more like the canny frog. They will weigh up their chances and dart their tongues out and catch the fly. Or they will miss the fly and learn from their mistakes, correcting and tweaking their techniques. You can be like the frog, but in order to do it you have to become more sophisticated. Weigh it up, ask some questions.

Source: http://www.huffingtonpost.com/john-bates/borsa-italiana-hft_b_1298943.html