SEC and HFTs. Clearly On The Wrong Track To Fix Layering
The Securities and Exchange Committee is proposing to build a multibillion dollar computer system to monitor stock trading real time. The proposed system, called Consolidated Audit Trail, or CAT, is designed to specifically track high frequency trading robot (HFT) trades. The question is...will CAT actually work or will it ignore the real problem.
Mary Schapiro, SEC Chairwoman, explained to Congress that the SEC's current ability to track trading data is "wholly inadequate to the task of overseeing the largest equity markets in the world." For this reason, a new system must be designed to monitor trades.
The operative word here is "trades," actual buys and sells. The problem facing traders now may not be the actual fills, however, but the quotes leading up to the fills. This is where HFT's are creating havoc for traders today.
HFT robots undermine trading legitimacy by "Layering" their trades. Layering is the action of robot programs making large offers to buy or sell securities that they have no intention of executing. As the price of the security approaches their offers, these robotic programs cancel their orders quickly.
Traders live and die by what is known as the "Level II". Level II is the quote system used by the NASDAQ, NYSE, and CME exchanges to provide real time display of buyers and sellers and their trades. Level II shows Bids (offers to purchase) arranged in price order from the highest price someone is willing to buy the security for, to the lowest price. Level II also displays Asks (offers to sell) arranged from the lowest price someone is willing to sell their security for to highest price.
Level II helps daytraders determine their security's "depth" (the different prices traders are willing to buy or sell their securities for). Because Level II displays an entire price ladder from lowest to highest, Level II is the major source of liquidity for daytraders. Lots of shares or contracts at each price level shows a heavily traded market, and may be a good time for daytrading. Conversely, a "thinly" traded market, with few shares or contracts waiting to execute, may be a market traders want to stay away from. Daytraders use Level II as a deciding factor in placing a trade or just sitting on their hands.
Now, because of Layering, the Level II price ladder that daytraders have been relying on for years may no longer be trustworthy. While shares or contracts appear ready to trade at different prices, in fact those offers are just being cancelled right before the price is hit. Traders are making faulty decisions based upon fantom, disappearing offers to buy or sell. Layering misrepresents market depth and disguises whether the market is heavily or thinly traded.
Say a stock is trading at $25/share. Looking at the Level II ladder, on the buy side you can see many shares at $25, $24.99, $24.98, $24.97, $24.96, waiting to execute. As a daytrader, you make an offer to buy at say $25.97, believing that there really are buyers at these levels and that the market is currently heavily traded. Your trade is filled but just as that happens, you see the offers to buy literally evaporate. These were phony to begin with, and in truth, the security was really thinly traded, not heavily traded at all. Now you have difficulty exiting your trade and you end up taking a loss.
The main problem is...if the SEC is building a computer system that only audits actual trades and does not look layered phony Level II bids and asks, then don't bother to spend the money building the computer system.