High Frequency Trading and Pricing Regulations

It all began with a tweet, moments ago. Degree Raju, a train travel attempter (I don’t know how often he manages to actually travel since he never seems to get tickets) tweeted this:

It is an apt analogy. The reason high frequency trading exists is that there is regulation on what the minimum bid-ask spread needs to be – it needs be at least 1 cent in the US, and at least 5 paise in India (if I’m not wrong). If the best bid (quote to purchase a stock) is at 49.95 and the best ask (quote to sell a stock) is at 50.00, there is nothing you can do to get ahead of the guy who has bid 49.95 – for regulations mean that you cannot bid 49.96!

The consequence of this is that if you want to offer the best bid, at a price close to 49.95, there is no option but for you to be the first person to have bid that amount! And so there is a race among all possible bidders, and in order to win the race you need to be fast, and so you co-locate your servers with the exchange, and so you (and your co-runners) indulge in what is called High Frequency Trading (this is a  rather simplified explanation, and it works).

Tatkal ticket booking has a similar pricing anomaly – the cancellation charges on Indian railways are fixed, and really low. Moreover, fares are static, and are not set according to demand and supply. More moreover, the Indian Railways suffers from chronic under-capacity. The result of all this together is that if you need to get a railway ticket, you should be the first person to put a bid (at a fixed price, of course) for that ticket, and so there is a race among all ticket-buyers!

In case the pricing of railway tickets was more flexible – either dynamic pricing according to demand, or higher cancellation charges (as I’ve noted here), this mad race (pun intended) to buy tatkal tickets would not be there. The way things are going I wouldn’t be surprised if agents want to get servers co-located with IRCTC servers so that they can procure tickets the fastest.

With HFT in stock prices, if only there were no limit on the minimum tick size – let’s say that a bid or an ask could just be any real number within a reasonable (say 6-digits?) precision, then in order to have the best bid, you need not be the fastest – you can compete on price!

Thus, HFT in stock markets and tatkal ticket booking are two good examples of situations where onerous regulations have led to a race to be the fastest.

And all this ties in with this old theory I have which says that the underlying reason for most financial innovation is stupid regulations. Swaps were invented because the World Bank could not borrow with floating (or was it fixed?) interest rates. CDOs became popular because AAA rated instruments required lower capital provisioning than home loans. Such examples are plentiful..

One thought on “High Frequency Trading and Pricing Regulations”

  1. Well put. The only differences is that the railways is trying to make tickets non-fungible (what, with PAN Card and what not?).

    There seem to be three broad ways to handle / deal with HFT:

    a) Your article – Efficient Markets. Must make world better. Make price rather than speed differentiator.

    b) The IEX route – Efficient Markets only in the limit. They dont really exist. Let’s add a (possibly random?) delay to all trades.

    c) Tax the HFT tax – Increase cancellation charges.

    As much as I am a fan of c), the government tends to be more socialistic in its purview. That leads it to:

    d) Puts quota. Tatkal Quota. Armed Services Quota. Senior Citizens Quota. Station wise Quota. Ladies Quota. Railways employees Quota.

    Sigh. 🙂

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