Fintech and the impact on trading
di Pario Panza
The advent of the block-chain technology in Fin-Tech has raised the question of the impact this is going to have on trading activities.
The following article intends to provide the reader with a general overview of how the interaction between Fin-Tech and market infrastructure can change the way people trade. Secondly, the author will argue to what extent the general adoption of the block-chain technology could free the market from the “bad guys”, namely HFT and speculators.
Since their foundation in the early 1600s, stock exchanges have provided a secure and reliable infrastructure that facilitates the transfer of financial resources between savers and borrowers (equities and bonds) as well as the distribution of risk according to preferences (derivatives). The exchange industry expedites such exchanges by reducing information asymmetries and transaction costs. Moreover, exchanges perform a regulatory function that guarantees the selection of participants (either listed companies or trading members), the orderly and fair execution of trades and the fulfillment of the related post trading activities (i.e. clearing and settlement operated by a central counterpart). Block-chain has the potential to further reduce such asymmetries and costs and to replace the central counterpart with a peer-to-peer mechanism. As a consequence, stock exchanges represent one of the major fields that the new technology is expected to impact. However, it is argued, block-chain technology is deemed to be unfit to offer a valuable alternative to trading platforms and ATS due to the speed limits featuring the ledger. Before engaging in new trades, a trader would have to wait for the settlement of the prior. Moreover, the employment of the distributed ledger implies the possession of the assets. The two aforementioned features “de facto” thwart High Frequency Trading (HFT) and margin finance (derivatives). Therefore, it is believed that what is truly going to be overturned from the inception of block-chain are a those activities (such as clearing, settling, net-off) that can be subsumed under the label of “post-trading” activities. Currently, post-trading activities require the intervention of a central counter-part functioning as an “absorbing entity” of the counter-party credit risk. Thus, trades are broken into two parts: the central counter-part acts as a seller to every buyer, and a buyer to every seller. The service provided by the previous-mentioned institution, however, comes at a cost: a fee is due for each trade cleared and settled, moreover parties are required to post collateral.
The latter scenario is going to change dramatically: the implementation of a distributed ledger will render the existence of the central counter-part superfluous. In a world where each party is capable of ascertain the solvency of the counter-party through the block-chain technology (where each trade is adjourned at real time), the need for guarantees on trades is lessened. In turn, the absence of a central counter-part will make trading cheaper, since no fee will have to be paid and no collateral to be posted as guarantee.
Turning now to the second part of the article: block-chain as a tool to get the market rid of speculators and HFT.
Scholars argue that block-chain technology will enjoy scarce application in trading due to the fact that a transaction validation requires much more time than a simple matching mechanism. Consequently HFT, whose activity consists in submitting buying/selling orders in the system quicker than the other players, would be impaired to implement their strategies. Further, due to the fact that block-chain technology, in order validate the transactions, requires the parties of the bargain to have possession of the trading assets, speculators would be prevented to act in the marketplace. What could be drawn from the previous lines is trivial, but rather meaningful: in the opinion of the author, absent compelling laws addressing the issues at hand, implementing the distributed ledger technology in trading could eradicate HFT and speculators from the market. Indeed with the unfolding of the financial crisis the argument that speculators vest the role of a white knight, providing players with a hedging need with a reliable counter-part. When it comes to HFT the many flash-crash happened over the past decade and the minor role played in terms of liquidity providers should spur a general rethinking on the impact of HFT on the market as well as on the reasons of their very existence. Contrary to market makers they are shielded from the obligation to guarantee liquidity on the market, therefore they act only on assets which are already liquid. Their strategies are based on front-running other players through posting orders (which are then withdrawn before execution) on exchanges in order to capture major players’ orders; they later anticipate the order captured acting as the seller to the major players and profiting from the net amount of the sell and buy trades. To conclude HFT provide shadow-liquidity (they do no hold the assets for long period of time) to assets which are already liquid resulting their activities in higher prices for investors purchasing the assets which HFT have acted upon. The negative impact of HFT on general welfare is blatant. Technology has brought forward a tool the market could deploy to put to bed once for all the previous-mentioned devilish activity. Should it be implemented?