The IEX decision has re-ignited a polarizing debate about speed being good or bad for markets. What if there is alternative to those two camps? If we think of speed as a proxy for price certainty, how would our perception of it's role in modern market structure change?
The recent decision over the IEX has once again re-ignited debate about speed and its role in today’s electronic traded financial markets. Unfortunately this debate often polarises people into one of two views – speed is good for markets or speed is bad for markets. This is a little simplistic but does fairly describe the argument and actions of people in their respective camps. I believe we are at a point where we should be re-thinking the role of speed in financial markets. The current mental model is limited and needs to be updated. What follows is a four part blog series where we explore the new role of speed in modern market structure.
In 1829 the British built the Royal Calcutta Golf Club (RCGC) in Kolkata. It is today, the oldest golf club in India and was the first outside Great Britain. When the golf course first opened for play, the British encountered a new type of problem. Monkeys would drop out of the trees, scurry across the course, and take the golf balls. The monkeys would play with the balls, tossing them here and there. Some of the time the player’s position was disadvantaged by where the monkey dropped the ball and some of the time the player’s position was advantaged. The outcome was largely random. This was a major disruption to the game that is governed by a strict set of situational rules and personal etiquette. At first, the golf club officials tried to control the monkeys. They erected high fences around the fairways and greens. This held some promise initially, but pretty soon the officials discovered that these fences were no challenge for ambitious and creative monkeys. Next, the officials tried capturing and relocating the monkeys, but there was no shortage of other monkeys that would take their place. They tried loud noises to scare the monkey’s away. Nothing worked. In the end, they arrived at a solution. They added a new rule to the game – “Play the ball where the monkey drops it”. This was referred to as “the monkey rule”.
The recent debate and argument about IEX, can’t help but remind us of the situation faced by the Royal Calcutta Golf Club officials. Unfortunately, it seems likely our industry will repeat the pattern followed by the British golf officials, with similar results. While analogies are never perfect, the reader will recognise some obvious parallels in the actions already taken by regulators, venues, and participants to tame the speed monkey. The introduction of “speedbumps” is the latest action. But this follows a long list of actions already taken in an attempt to counteract effects of speed. Remember the rules for equal length cables in co-location facilities and Reg. 603a rules for price distribution on direct versus consolidated feeds. What about the attempts to round up those pesky prop-traders and ship them off only to have them re-appear in the form of quant hedge funds. Can anyone see a pattern emerging here? My prediction is that all these actions will ultimately prove ineffective as we look to build a robust, transparent and fair market structure. There needs to be a collective understanding and acceptance of the true nature of speed and the role it plays in market structure. Only then, will it be possible to see what sensible rules might be put in place which cuts through the “Gordian knot” that has emerged from the adoption of high-speed trading technology.
Speed can be thought of as a proxy for price certainty. In a faster market, you are more likely to secure the price as advertised, i.e. the price is less likely to have moved when you attempt to execute a trade. In a slower market, the price advertised is more uncertain. It may have moved by the time you can respond to it, i.e. the price you receive in a slow market might be stale.
An analogy is to think of speed and its impact on market price to be like the weather. The weather is a random natural phenomenon. It changes constantly. It is hard to control. It operates as a complex, dynamic and a highly interdependent system. There are seasons where the weather is warmer e.g. summer. There are geographies where we expect the weather to be colder or wetter. But on any day, of every season, everywhere on our planet there is a level of uncertainty as to the what the weather will be. This is something we accept without much questioning.
What if we decided that it is unfair for all humans on the planet to experience different weather? How would we solve this problem? There are two approaches that one could take. Approach one would be to move all people on the planet to the same location. We would probably have to stack people on top of each other to fit them into a space where it would be precisely the same weather. Approach two would be to build an atmospheric shell around planet and then precisely control the system such that we can deliver the same weather experience to everyone. Most would accept these ideas as ridiculous and futile. We have learned to live and adapt to the weather we are given day for day. Even if we live in a country or state with poor weather relative to another location, we often choose not to re-locate because there are other aspects of where you live that are more important to your quality of life e.g. family.
However, there are two really important things we do as a society in dealing with weather. Firstly, we attempt to gain better insight into weather patterns and make better predictions with weather forecasts. This becomes critically important for people whose daily lives depend on knowing the weather e.g. fishermen. Equally, being able to predict major storms and taking appropriate action is a consequence of us dealing with something that is inherently random and difficult to control. Second, we now finally realize the importance of protecting the planet from global warming. We understand as a global society our actions are impacting the integrity of how our weather system works. This is where we need our governments to step in and help. Therefore, there are three really important things that regulators need to do relative to the speed question in electronic traded markets: