For the past month, high-frequency trading has been under attack. The first volley came on a Sunday night in late March, when author Michael Lewis, introducing his new book Flash Boys on the news magazine program 60 Minutes, delivered the most perfectly succinct of all headline-grabbing comments. “The markets are rigged,” he told correspondent Steve Kroft, implying that high-frequency traders front-run the market and are cheating ordinary investors.
Since then, the imagery used to battle HFT has only grown more fanciful and over the top. Charles Schwab, founder of the brokerage firm that bears his name, called high-frequency traders a “cancer,” and Jim Kramer told his CNBC audience that “defending high-frequency trading is no different than defending the mosquito.”
One voice that has been drowned out in the noise surrounding the controversy over HFT practices has been that of high-frequency traders themselves. So what do high-speed traders think of the mounting accusations against them? In a word: “Nonsense,” said Manoj Narang, founder and CEO of HFT firm Tradeworx. “There is no front-running that high-frequency traders engage in.”
Part of the evidence presented in the 60 Minutes segment and in Lewis’ book for how high-frequency traders get ahead of investors included the account of Brad Katsuyama, founder of the IEX dark pool, who recalled that during his time at the Royal Bank of Canada, traders would execute trades at several exchange simultaneously, only to see the trades partially fulfilled. Katsuyama’s team determined that after a trade was executed in the first market it hit, high-frequency traders at other markets would cancel or adjust their prices before the rest of the trade could be executed. In essence, they were moving the market away from the trade with only part of it completed.
Narang takes issue with those front-running allegations on several counts. “First of all, front-running has a specific legal definition. It means giving your order more preference than a client’s order that you are entrusted to execute on their behalf,” he told Traders. A problem with applying that definition to HFT, he said, is that high-frequency traders don’t have clients. They are simply liquidity providers who are posting quotes without acting on anyone else’s behalf.
But more importantly, Narang argues that the HFT behavior that its detractors are taking aim at is simply an example of trading following the basic rules of supply and demand. The charges against it show a lack of understanding of both the natural behavior of financial markets and the functionality of the technology that underpins it, he said.
High-frequency traders don’t see an order as it travels down the pipes, he explained in April as the HFT debate was raging in the press. “The fact that an order is on a feed means it is already at an exchange,” he said. “There is no way to get ahead of it once it is there. All high-frequency traders do is, they use publicly available information as intelligently as possible.”
An order that needs to be executed across several exchanges likely has some size to it. Firms have always sought to minimize the impact on the market of moving large orders, but Narang argues that is a fight against natural market forces. “It’s not possible to avoid moving the market with a large order. The reason the market goes up is more buyers than sellers, and the reason the market goes down is more sellers than buyers, and the reason for that is that buying or selling large blocks of shares impacts the market,” he said. “It’s supposed to. That’s why we have prices.”
On this point Narang seems to have the sympathy of regulators. One regulatory representative privately compared the situation to a customer trying to go into multiple stores at the same time. If the customer goes into the first store and buys out all of one item, another store that sees that the first store is sold out will want to change its price.
Yet regulators are aware of differing points of views from participants who are frustrated by how their orders get filled. Meanwhile, one market observer notes that the frequent cancellation of orders may unnerve basic investors, who may not be looking to move large orders, but simply looking to execute on a live price. Aite Group senior analyst David B. Weiss uses the analogy of someone going to the store to buy milk, only to see large amounts of it disappear from the shelves just when they want to buy it. “If it’s not wrong or not illegal, it’s just weird,” he said. Weiss suggests that part of the solution could be for all liquidity providers-not just designated market makers, but high-frequency traders as well-to be required to post continuous liquidity. “You just can’t pull liquidity in a crash,” he told Traders. “You have to provide continuous quotes so that it’s a right and a responsibility.”
A Contentious History
While the current megawatt spotlight on HFT is new, the debate about its impact on the market has gone on for longer than many realize. In 2010, the Securities and Exchange Commission issued a concept release on equity market structure that invited public comment on HFT, among other issues.
In its public response to that concept release, Tradeworx supplied research that showed that, on average, prices move against liquidity providers. “We analyzed every single trade on every single exchange from the perspective of the liquidity provider,” Narang recalled. “In a one-minute time period, for example, if you were to calculate the average P&L of a passive order from the market maker’s perspective, it’s negative.”
Narang sees this as proof positive that high-frequency traders are not market manipulators. “That’s pretty conclusive evidence that people are not manipulating prices,” he said. “Otherwise prices would be moving in favor of the market maker, not against us.”
Furthermore, according to Narang, often it is exchange rebate fees that help market makers maintain profitability. “The only reason why the market makers can concurrently stay in business is because they have a liquidity rebate,” he said. “It’s offsets against that which turn them into something marginally profitable.”
But this leads into an even stickier debate.
Maker-Taker Pricing
The issue of maker-taker pricing and its relationship with high-frequency trading may be the most contentious and complex of all. One industry trade group representative cautioned that there is a diversity of views on the topic, but noted growing concern that “it may not incent the right kind of behavior.” The role of rebates in the high-frequency trading business model is a big part of the concern. “If the whole reason for trading is to capture the rebates, rather than profit off of trading, is that the right structure?” he asked.
In an April speech, SEC Commissioner Luis Aguilar-expressing his own views and not necessarily those of the commission-also drew attention to the maker-taker link to high-frequency trading. Claims that maker-taker “has incentivized some market participants, including high-frequency traders, to trade primarily, if not solely, to profit from collecting maker-taker rebates” should be explored more fully, he said. Aguilar advocated the idea of a pilot program whereby maker-taker rebates would be temporarily halted from certain stocks to better study their effect on the market.
But another regulatory representative notes that markets without maker-taker pricing do exist-the IEX market profiled in Flash Boys being one of them. Yet he challenges the idea that HFT strategies are dependent upon rebates. Rather, he argues that rebates are factored into mathematical models that high-frequency traders use to generate quotes. If the rebate were eliminated, quotes would simply be wider, as the rebate would no longer be part of the quote-generation calculation.
SIP and the Speed of Market Data
Meanwhile, the other speed involved in high-frequency trading is the speed of data. In a campaign his office calls “Insider Trading 2.0,” New York Attorney General Eric Schneiderman has set his sights on services that offer certain segments of the market faster access to data than others, and services like direct data feeds and co-location are assumed to be among the services Schneiderman is investigating.
The Securities Information Processors or SIPs, run by Nasdaq and the New York Stock Exchange are the feeds that publicly disseminate data throughout the market. The SIPs came under scrutiny last summer, when a glitch with the Nasdaq SIP led to a halt of trading on the exchange for nearly three hours. In December, the Securities Industry and Financial Markets Association called the technology that underpins the SIPs woefully out of date.
Yet even when the SIPs are at their fastest, they are quote aggregators, meaning they will by definition deliver data with a slight time delay, compared with a direct high-speed data feed coming from an exchange. Defenders of direct data feeds note that they are not only in the hands of high-frequency traders but they are used by most sophisticated market participants. But increasingly, many see this arrangement as unfair.
“Public market data should be released to all market participants simultaneously,” wrote Goldman Sachs chief operation officer Gary Cohn in a Wall Street Journal editorial in March. “Removing the possibility of differentiated channels for market data also reduces incentives that favor investment in the speed of one channel over the stability and resilience of another.”
One solution might be to remove the SIPs from the exchanges’ control, if for no other reason than to remove the conflict of interest, said Aite’s Weiss. “Take the purview for the SIP outside market operators,” he said, adding that, if necessary, regulators could also slow down direct exchange feeds so that they didn’t beat the SIPs to the delivery of information. “The SIP is basically everybody’s feed, so make it everybody’s feed,” he said.
The Offenders
While it may seem to the parties complaining about high-frequency trading that the approach of regulators toward the issue has been too laissez-faire, both the SEC and the Commodity Futures Trading Commission have brought charges against firms for using HFT practices in ways the agencies viewed as deliberately deceptive.
In November, the CFTC charged HFT firm DRW Investments with manipulative practices in the IDEX USD three-month interest rate swap futures contract. The closing price of the product is often determined during a 15-minute settlement window, and on 118 different days, DRW manipulated the price of the contract by placing multiple erroneous bids, the CFTC said. The practice, which is similar to quote spanning or spoofing, netted DRW $20 million, the agency said.
In April, the SEC charged owners of Visionary Trading with manipulating the national best bid and offer, or NBBO, for certain stocks, alleging that a co-owner of the firm deliberately sent false signals to the market through a process of placing and canceling orders he never planned on executing.
The SEC has also recently completed an equity market structure literature review on HFT, which synthesized and summarizes 31 research papers on the topic of high-frequency trading. The review is an attempt to collect a broad cross-section of perspectives on the effect of HFT on the markets, though in several cases, the results of different papers contradict each other.
Meanwhile, Narang maintains that high-frequency traders are simply playing the role that liquidity providers have always played in the market. The only difference is that in today’s markets, that role must be played at mind-boggling speeds.
“Even 30 years ago, people who were making market on exchanges traded with high frequency-they wanted to turn their inventory over as quickly as possible to try to capture as much of the bid-ask spread as they could,” Narang said. “Nothing has really changed except the extent that computers are involved in that business model.”
