Do regulators understand countervailing power in markets?

Practitioners understand the importance of countervailing power in keeping markets clean. The biggest obstacle that a would-be manipulator faces is a big player on the opposite side with the incentives and ability to block the attempted manipulation. Without that countervailing power, the regulator would be stretched very thin trying to combat the myriad games that are being played out in the market at any point of time. But regulators seem to be oblivious of this completely and often step in to curb the countervailing power without realizing that they are allowing people on the other side a free run.

This was highlighted yet again by a recent order of the UK Financial Conduct Authority (FCA), the successor to the Financial Services Authority (FSA). The FCA fined Michael Coscia for a trading strategy that made money at the cost of high frequency traders (HFTs).

HFTs often try to trade in front of other people. When the HFT suspects that a large trader is trying to buy (sell), the HFT tries to buy (sell) immediately before the price has gone up (down), and then tries to turn around to sell to (buy from) the large trader at an inflated (depressed) price. Michael Coscia created a trading strategy designed to give the HFTs a taste of their own medicine in the crude oil market. He placed a set of large orders designed to fool the HFTs into thinking that he was trying to sell a big block. When the HFTs began front running his purported large sell order, Coscia turned around and bought some crude from them at below market prices. He then performed the whole operation in reverse, fooling the HFTs into thinking that there was a large buy order in the market. When they tried to front run that buy order, Coscia sold the crude (that he had bought in the previous cycle) back to the HFTs.

The FCA thinks that Corcia violated the exchange rules which provided that “it shall be an offence for a trader or Member to engage in disorderly trading whether by high or low ticking, aggressive bidding or offering or otherwise.” From a legal point of view, the FCA is probably quite correct. But the net effect of the action is to neutralize the kind of trading strategies that would have held the HFTs in check. The FCA of course thinks that they are acting against HFTs because Corcia’s trading strategy also involved high frequency trading.

Posted at 2:29 pm IST on Sun, 4 Aug 2013         permanent link

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