High frequency trading (HFT) has gotten a lot of press over the last several years. The so-called “Flash Crash” of May 2010 highlighted the impact HFT can have on the markets, though the focus has mainly been on the stock market. No real surprise there. The average person on the street still thinks of stocks first when the subject of trading comes up. That’s not the only place HFT’s influence is being seen, though, as a recent newswire piece indicates.
Here’s the first part of the Dow Jones story (which can be read on the Wall Street Journal site here):
Electronic inter-dealer currencies-trading platform EBS plans to scrap the fifth decimal place on its currency quotes and introduce so-called half-pip pricing ahead of major changes to the system, people familiar with the matter told Dow Jones Newswires Tuesday.
EBS, owned by ICAP PLC (IAP.LN), has been considering a range of options that will change the way investors are allowed to trade on the system in a bid to repair relations with its core banking customer base. EBS shares a dominant position in currency markets with Thomson Reuters (TRI), but it has come under fire from its core bank clients for allowing trading behavior that seemingly favors so-called high-frequency traders in recent years. Now it is seeking to redress that balance.
This article caught my attention because I recently reviewed a book titled Broken Markets on the subject of market structural changes and how HFTs have been able to exploit them. One of those changes is the move to decimalization made by the stock exchanges in the US in 2000. That helped narrow bid/ask spreads, which lowered trading costs. According to the book’s authors, though, it also created a lot more price points for trades to take place, leading to thinner liquidity at any given point, which is something noted in the Dow Jones story from the forex perspective. It also created greater opportunity for HFTs to come in and do their thing (some of which is highly predatory). The introduction of pipettes (fractions of pips) in forex has served the same purpose.
The move by EBS, as motivated by their customers (mainly the major banks – see The Dominant Players in Forex), is to pull that back a bit. The banks are feeling the pressure in their dealing margins, which have already been squeezed considerably. Back when I started in this business the bid/ask spread on USD/JPY was consistently 10 pips and up. It’s more like 2-3 pips these days most of the time, which means the banks who are acting as market makers are making much less profit per trade. This spread compression, combined with rapid technological development, has been a big factor in the shrinking of the global foreign exchange business. You can understand why the banks wouldn’t want to see those spreads narrowed further, especially if HFTs are grabbing a rising share of the volume.
If EBS makes the move to limit pipettes to only half pips, as proposed, that could have an impact on retail forex broker pricing. Exchange rates cascade down from the inter-bank market to the retail one, so any development at the top end where EBS operates is likely to filter its way to broker platforms. Not that it’s likely to have a major impact on most individual traders’ strategies.
The other thing EBS is looking to cut down on is the kind of quote stuffing that can lead to illusory liquidity. This quote stuffing happens when an HFT submits quotes/orders to the market really only to identify liquidity and feel out price direction. A high percentage of these orders are quickly cancelled. EBS wants to crack down on this, which could have an impact on price action. That may end up being the bigger thing to keep an eye one moving forward. If it tends to smooth out prices we could find forex becoming that much more interesting for that money flowing out of the stock market.
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