Economic Confidence Eroded: Virtual Currency & HFT

By Rachel Ehrenfeld, Ken Jensen
Wednesday, February 13th, 2013 @ 3:55AM

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The latest worry among those who are concerned about the digitalization of commerce and the erosion of market confidence seems to be the growing phenomenon of virtual or “alternative” currency. The originator of virtual currency as an easy-to-use convenience was one Satoshi Nakamoto, who created Bitcoin.  Its website explains:

“Bitcoin is one of the first implementations of a concept called crypto-currency which was first described in 1998 by Wei Dai on the cypherpunks mailing list. Building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context, Bitcoin is designed around the idea of using cryptography to control the creation and transfer of money, rather than relying on central authorities.”

Unlike actual currency, Bitcoin does not rely on issuance by a central bank or government, and fluctuates in value outside the traditional money markets: “Bitcoin has more than doubled in the past 12 months, strengthening to $16.37 from $5.88, according to data from Mt. Gox, the world’s largest bitcoin exchange. The money, issued by a decentralized network of computers, has recovered after falling to $2.14 in November 2011 from a high of $29.58 five months earlier.”(Emphasis added).

STRATRISKS asserted recently that virtual currency traders like Bitcoin could threaten central banks. Indeed, theEuropean Central Bank was concerned enough to issue a detailed report in October 2012. The report explains how virtual money schemes have

“No physical counterpart with legal tender status. The absence of a distinct legal framework leads to other important differences…. Firstly, traditional financial actors, including central banks, are not involved. The issuer of the currency and scheme owner is usually a non-financial private company. This implies that typical financial sector regulation

and supervision arrangements are not applicable. Secondly, the link between virtual currency and traditional currency (i.e. currency with a legal tender status) is not regulated by law, which might be problematic or costly when redeeming funds, if this is even permitted. Lastly, the fact that the currency is denominated differently (i.e. not euro, US dollar, etc.) means that complete control of the virtual currency is given to its issuer, who governs the scheme and manages the supply of money at will.”

We’ve recently witnessed the beginning of a new era when individuals with computers can take part actual war. Now, individuals with computers can create money and manage its supply.

Virtual currency, like high frequency trading, increases the vulnerability of markets. As importantly, it erodes confidence in physical money and markets. The current administration seems to be entirely indifferent to the matter of maintaining confidence in the economy, which largely rests on market confidence.

Which brings us to HFT:

Not every problem with HFT has to do with algorithmic glitches and flash crashes.  It also has to do with mysterious share price fluctuations caused by HFT manipulations, which, of course, have affected the confidence in the market.

If the market cannot be relied upon to function properly given unpredictable and artificially produced changes in share value, who will want to invest in equities?  Declining confidence in this, and other parts of the economy, is surely something our adversaries would welcome and facilitate if they could. We seem to be sitting calmly by with market vulnerabilities that erode confidence, as if we were waiting for our adversaries to finish us off.

Eric Pritchett, head of Potamus Trading, has offered a good explanation as to how we got to this juncture. He writes that the key to healthy financial markets is competition between exchanges. Market regulator SEC attempted to assist this in 2006 when it put out the Regulation National Market System (RNMS). However, in addition to promoting competition, the RNMS “also tilted the balance of power within the market-making industry decisively towards large high-frequency trading firms as scale becomes critical.”

Accordingly, concentration of trading is only increasing at the expense of healthy competition. Knight Capital, for example, has been bought out by HFT competitor Getco, which is now the largest market maker on the New York Stock Exchange, with 30 percent of U.S. equities volume.

As Pritchett says, the result of the RNMS and subsequent growth in high-frequency trading led the exchanges to accommodate their largest trading firms, thus contributing to “an atmosphere of corrosive distrust.” This in turn generated the perception that exchanges are like casinos “rigged to favour the big traders who have the closest relationships with them.” And the small investor is left on the sidelines.

In recent weeks, major exchanges NYSE Euronext, BATS Global Markets, and Direct Edge have admitted that they’ve not always traded shares at the best available price. However, they claimed this lasted for a short time, between four minutes at the NYSE, to four years at BATS, costing investors some $420,000 in the latter case. However, not trading at the best available price is against U.S. law.

While technical remedies to the problems caused by HFT are talked about in a discussion that seems to have no discernable end, some are considering HFT’s wholesale elimination. Congressman Ed Markey (D-MA), a longstanding opponent of HFT (i.e., since 1989), recently wrote to the SEC asking it to consider that it eliminate HFT altogether: “If the commission simply makes a finding that the markets are currently in a period of extraordinary market volatility and that HFT is reasonably certain to engender such levels of volatility, the Commission can immediately promulgate rules that restrict or eliminate the practice.”

Clearly, the time has come to take care of the HFT problems.

TABB Group of New York has published a report on the state of U.S. equities in 2013.  Among its findings is that HFT as a percentage of trading volume will rise to 52 percent this year and generate $2 billion in revenues.  Off-exchange trading volume, which was at 33 percent in 2012, will increase.  TABB also points out that, although the markets may have not been significantly affected by HFT yet, investor confidence is poor and continues to decline.

Whatever else can be said about virtual currency and HFT, there are clear indications that the U.S. financial markets–and, therewith, Western economies on the whole–are increasingly vulnerable to cyber attacks and manipulation.

The security and stability of our financial markets is dependent not only on solving electronic price manipulation and algorithmic glitches, which should have been done yesterday, but also on developing better monitoring systems and allowing fair competition. These would be helpful to stabilize the markets and build confidence. However, lacking an advanced cyber security system, our financial markets remain exposed to foreign cyber infiltration.

FURTHER READING:

FINANCIAL TIMES: New [HFT-dominated] Bourse Launched in India

Rhodri Preece: The pros and cons of dark pools of liquidity

FierceFinanceIT: High-frequency trading: Clear and Present Danger?

BLOOMBERG: Texas Day Trader Sued by SEC Over High-Frequency Trading Claims

BUSINESS INSIDER: What It Looks Like When A High Frequency Trading Algo Bombs A Stock With Fake Quotes

Andy Mills: Fast Cash Dash Flash Crash Clash


Categories: ACD/EWI Blog, Cyber

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