Let's Share

HFT Front-running in Commodity Markets?

After being consumed by and pissed off at the system after reading Flash Boys, I started to wonder if something like that (electronic front-running) can happen on the commodity exchanges. After all, we have many commodity changes here and abroad, just like the equity markets.

The answer to that, has lead me to understanding the concept of order flow and exchange requirements. Futures exchanges are different due to a difference in the treatment of orders -- they own their order flow. Meaning, if there was another exchange posting a better price, the futures exchange is not required to direct the order to a better priced market. Yes, you read that correctly. This means that the traders direct their orders to the exchange where they think they will get the best price. This creates growing momentum that causes one exchange to be dominant including products it trades, thereby providing liquidity and all the other good stuff that goes along with it. But we digress...the other benefit is the commodity futures exchange is not required to distribute the order to another that has a better price - which makes it difficult to game the system by putting a false better price on another exchange and then buying up all of the supply near that price and selling it back to the original orderer at a higher price. Did you get all of that?

In the equities markets, the NYSE prior to 2005 had the same rule, and owned 80-85% of the trading volume. In 2005, the SEC changed the rules with RegNMS, and required exchanges to route orders to others displaying better prices. Good in theory, but technology and conniving minds figured out a grand front-running scheme - cue evil laugh - which is the basis for Michael Lewis's book.

Those damned unintended consequences will get you...but I do feel better that it is harder to front-run the commodity markets in the same manner as the equity markets. And now that the FBI and other agencies are investigating, we should start to see regulation reform. Hopefully sooner than later.