High-frequency trading under scrutiny

By Michael Mackenzie in New York Published: July 28 2009 18:44 Last updated: July 28 2009 18:44 The lightning fast world of high-frequency equity trading is being scrutinised by the Securities and Exchange Commission, amid concerns that this computer-dominated scene is placing less tech-savvy investors at a disadvantage. Volumes of trading generated by computers placing super-fast orders – where speed of execution is measured in microseconds – to generate business has rocketed in recent years. The Tabb Group, a consultancy, recently estimated that high-frequency trading accounts for as much as 73 per cent of US daily equity volume, up from 30 per cent in 2005. Tabb estimates these players, some of the largest of which are hedge funds such as Citadel, D.E. Shaw & Co. and Renaissance Technologies, represent about 2 per cent of the 20,000 or so trading companies operating in the US markets. It is a consequence of three trends in equity trading: the introduction of electronic platforms run by exchanges Nasdaq OMX and NYSE Euronext; the growth in “electronic communication networks”, led by Direct Edge and BATS; and the surge in anonymous trading venues, known as “dark pools”, because they trade outside the mainstream market. Electronic trading has reduced the costs of trading equities for retail and institutional investors. But with the demise of old-fashioned floor brokers and traditional market makers, new so-called high-frequency equity players, which include proprietary trading desks at investment banks, have become the main providers of liquidity for the overall US equity market. Even in Europe, ultra-fast electronic trading has gathered momentum in the wake of the Mifid reforms passed by the European Commission two years ago. This has facilitated the arrival of platforms, including Chi-X Europe, Turquoise and a European arm of BATS. High-frequency trading strategies are generally geared towards extracting fractions of profit from trading small numbers of shares in companies, between different trading platforms at hyper-fast speeds. This pace of trading is known as “latency” and requires constant upgrading of computer systems to stay ahead of the pack. “High-frequency traders are the de facto market makers now,” says Stephen Ehrlich, chief executive officer at Lightspeed Financial, which provides trading technology and brokerage services for high-frequency traders. “They are using their own capital to provide liquidity for the market.” But the growing dominance of high-frequency trading has its critics. This month, Sal Arnuk and Joseph Saluzzi at Themis Trading raised the alarm with their paper: Why Institutional Investors Should Be Concerned About High Frequency Traders. “We’re not interested in demonising any one asset class, trading strategy, market participant or firm, but rather we want to shine a light on a system and make it fair for all investors,” says Mr Arnuk. They and other critics argue that high-frequency trading, which is being actively courted by the big US exchanges, results in retail and institutional investors chasing artificial prices and enduring heightened volatility. Exchanges pay small fees to active traders, usually a quarter of a cent per share in what is termed liquidity rebates. This, says Themis, has inspired trading that merely seeks to capture a rebate from an exchange, no matter whether the actual trade makes money. That churns prices and can force other investors to pay a higher price per share, as liquidity is sucked out of the market. “The culture of the equity market has been one where providers of liquidity are paid, while takers of liquidity are charged,” said Joe Mecane, chief administrative officer for US equities markets at NYSE Euronext. “It provides an incentive for liquidity providers.” Doubts about the value of high-frequency firms, however, compelled the London Stock Exchange this month to abandon paying rebates due to concerns that it was alienating its biggest customers, the large banks that channel orders from so-called buy-side asset managers and pension funds. Beyond rebates, another key concern is the practice of flashing prices, which helps market makers or investors discover where others want to buy or sell stocks. This practice is widely used by high frequency traders and is allowed by BATS, Direct Edge and Nasdaq OMX, while NYSE Euronext has been a vocal critic against the practice. Charles Schumer, a senior Democrat on the Senate Banking committee, says flashing prices creates a two-tiered market that disadvantages retail and institutional investors and he wants the SEC to ban the practice. In response, the SEC said it was “specifically examining flash orders to ensure best execution and fair access to information for all investors”. In a letter to the SEC this week, Bob Greifeld, chief executive of Nasdaq OMX, urged the regulator to examine the practice of flash orders and other aspects of trading. Larry Tabb, chief executive officer at the Tabb Group, says: “While many of the exchanges don’t even like flash orders, you can look at them as just another way of trading in the dark.” Both BATS and Direct Edge say any investor can participate in flashing prices or receiving them on their trading venues. Any move to ban the practice, says Direct Edge, is seen as creating a two-tier market as it is likely to push business away from the main electronic platforms towards “dark pools”. Still, there are concerns that market makers, such as high-frequency traders, cancel many of their flash orders before other investors can execute a trade. This can enable the market maker to come back and offer shares for sale at a higher price, or place a buy order at a lower level. “Certain black-box models have cancellation rates as high as 99 per cent on orders,” says Paul Zubulake, senior analyst at Aite Group. Mr Arnuk believes liquidity rebates and flashing should be stopped in order to level the playing field for all investors. Mr Tabb argues institutional investors need to raise their game to compete with faster computer systems. “The markets are changing and people need to upgrade both their technology and their people to keep up.”