Yeah, those guys who were ultimately responsible for everything from the Flash Crash to the Pan Am Lockerbie bombing and shooting J.R. Ewing. These traders, who relied on hyper-fast computers and fiber-optics, were in the news and everywhere you wanted to be – on 60 Minutes, C-SPAN and CNBC and taking a beating for their trading style.
Not much has been said recently about these so-called nefarious exploiters of the market structure. But wait, there was news this week from the U.K’s Financial Conduct Authority that found that high-speed trading practice of “latency arbitrage” is costing investors $5 billion a year. According to the FCA, traders and hedge funds who use high speed trading methods to gain an advantage in effect impose a “tax” on other investors who end up paying more to trade.
But that’s not exactly true, according to Jeff Mezger, director of product management at Transaction Network Services (TNS), a commonly held myth is that high-frequency trading (HFT) firms make things more expensive for everyone. Actually, HFT firms provide the liquidity needed to fuel the market, which makes it easier for investors to buy and sell.
Here, in his own words, Mezger spells out the Top 5 myths surrounding HFTs as he sees it.
Myth No. 1: High-frequency trading (HFT) firms make everything more expensive for everyone.
Many people, both within the financial service industry and outside it, have a perception that HFT firms are predatory; they make all the money while individual investors lose – a zero-sum game.
But that’s actually not true. For markets to work properly, you need lots of people participating and lots of money moving in and out from various sectors – i.e., lots of liquidity.
HFT firms provide the liquidity needed to fuel the market, which actually makes it easier for individual investors to buy and sell: Without a certain amount of liquidity in a particular market or commodity, they become more expensive.
Some allege HFT firms were responsible for the 2010 Flash Crash, but the crash actually proves these points; liquidity evaporated, everyone pulled out, and shares went down to a penny because no one wanted to buy.
In fact, HFT firms can help prevent exactly these kinds of issues by providing the liquidity that acts as a shock absorber for the natural ebb and flow of individual investors’ trades.
Myth No. 2: HFT firms have special access to data.
There’s a perception that HFT firms can gain information about the exchanges, including price, through certain backchannels that regular investors don’t have access to.
That’s not quite true. These exchanges are heavily regulated by the Securities and Exchange Commission (SEC) and the U.S. Commodities Futures Trading Commission (CFTC), and one of the regulations is a mandate granting everyone equal access.
There is a caveat to this one, however. The exchanges have different levels of service in terms of the market data they provide; the more someone is willing to pay, the faster they get information. This means it’s possible, in theory and practice, for HFT firms to get better information faster, but the fact remains that it’s available to everyone – even though not everyone wants to pay for it.
There have been outcries in the past against HF traders who received information about the results of their own trades before the market does, with some saying this grants an unfair advantage. Yet HFT firms only get this information as it pertains to their own trade activity; they effectively pay for the right to get data faster in exchange for taking on risk.
Myth No. 3: HFT firms drive smaller players out of the market.
Another assumption is that HFT firms monopolize exchanges; through the dollars and technology they bring, they usurp some of the smaller players, thus driving them out.
The first part does happen: It’s no secret that HFT firms bring a lot of money into an exchange (which is a good thing, as we saw in Myth No. 1). The myth here is that smaller players just hang up their hats and go home.
The smart ones, however, know how to survive, by taking the same strategy they used in competitive, mature markets and airdropping it into emerging markets.
Say a smaller firm makes a killing trading short-term interest rates on the CME, until the HFT firms come into the Chicago market and create more competition. Instead of closing up shop, what that smaller firm should do is look at other avenues.
The Australian market (ASX) also trades short-term interest rates. This smaller firm can take its strategy; trade on another, less competitive exchange, like the ASX; and continue to reap the rewards.
And while small firms may bemoan their lack of international resources, in fact, service providers are making it a snap to connect globally. The firm doesn’t need employees physically in Australia, or deep knowledge of the network routes and hardware providers there, or local broker relationships. Service providers bring all of this, taking the tough parts off the firm’s hands and creating access formerly only available to global conglomerates.
Exploring these new avenues is part of the “adapt and adopt” mentality that anyone involved in the financial service industry needs to have these days.
Myth No. 4: An HFT firm’s business model is solely based on speed.
Some believe HFT firms make their money only because of the speed at which they trade – they get from one place to the other faster than anyone else. While this is the bulk of their business, it’s not the entirety of it.
Like innovators in any industry, HFT firms also seek smarter ways of doing things via technology. We throw around the word “disruptive” so often these days because the new normal is the 2.0 version of anything; once a technology or methodology exists, you can expect that someone is going to find a better way of doing it.
Instead of depending on speed exclusively, some firms are looking to other ways to trade – for example, building a trading strategy on clock sync technology, which synchronizes clocks around the world based on location to create an advantage.
The future belongs to the disruptors (and the disruptors of those disruptors); it’s how we keep moving forward as a species. HFT firms are no different.
Myth No. 5: HFT firms do everything themselves.
Many accept the idea that HFT firms often are in a position to cull all their own information, build their own microwave towers, run all their own network routes, etc., and smaller firms don’t have the ability to do that, so that means they can’t compete.
False. While this is true in some markets – no, a smaller firm is not able to build their own shortwave radio towers between Chicago and London– it’s not true on a global scale.
Myth No. 3 touched on the idea of developing strategies for emerging and smaller markets and using service providers to allow smaller firms to compete. Here’s an open industry secret: HFT firms use these services as well, in emerging markets like Korea and Taiwan, giving them boots on the ground in a market they don’t know themselves.
The idea that smaller firms can’t compete because they don’t have the money to do everything themselves is a myth; service providers have leveled the playing field in recent years, creating friendly competition and ensuring even small firms can play in the markets.
Moving Forward
The prevalence of these five myths points to a lack of understanding about many aspects of high-frequency trading practices and advantages, and it’s important to set the record straight.
Having a better grasp of how HFT firms operate – and the ways smaller firms can capitalize on their advantages to become fierce adversaries – will move the industry forward and fuel competition, keeping markets humming and making everyone a buck.
High-frequency trading may not have quite gained acceptance – but at least the pitchforks have been put aside
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High-frequency trading has served as sort of a catch-all, market bogeyman phrase for about the past half-dozen years, or about as long as the methodology has been in the awareness of the general public.
The flash crash? High-frequency traders caused that. The Knight Capital algos gone wild debacle? That was high-frequency trading. The glitch-laden Facebook IPO? HFTs, for sure.
And of course there was Flash Boys, the highly publicized Michael Lewis book, in which the authors main conclusion was that the markets were rigged, and HFTs are the ones doing the rigging.
Its always going to be something that people throw under the bus whenever theres any kind of disruption, whether its market manipulation, outages, crashes, or anything else, said Spencer Mindlin, analyst at consultancy Aite Group.
But high-frequency trading has existed for at least 17 years now, and it has comprised a meaningful portion of U.S. equity trading volume for more than a decade. The U.S. Securities and Exchange Commission has looked at HFT for years, and not only has the regulator generally let it be, but its own economist has cited benefits of HFT.
So while high-frequency trades might have ultra-short holding periods, high-frequency trading has staying power.
For high-frequency traders, no news is good news, as a dimming of the once-white-hot spotlight allows for more opportunity for market participants and observers to understand HFTs beneficial role in the market. At least thats according to HFT advocates.
Weve witnessed an education of the marketplace, helped by academic studies and research, which in turn has led to a better understanding of the HFTs and the strategies that they employ, said Doug Cifu, chief executive officer of Virtu Financial. A few years ago, HFT was the industrys favorite scapegoat for things that the market participants didnt understand. Fast-forward to today, instead of pointing to HFT, the buy side is more advanced and capable of analyzing the executions they receive and the manner in which their orders are routed.
The more sophisticated buy-side participants are able to look at the data and ask meaningful questions of their algo providers, Cifu told Markets Media. Thankfully, data and transparency have squelched the rhetoric.
#DefineHFT
High-frequency trading has been a lightning rod for years, with strident backers, vocal detractors, and lots of gray area.
The gray area starts with the definition. HFT can be defined as computerized, algorithm-based trading characterized by high speeds, short holding periods, and high order-to-trade ratios. But there is no single definition of HFT, and asking 10 different market participants for their definition would likely produce 10 different answers.
Some research has shown that HFT is helpful to the market overall. In 2014, Austin Gerig of the SEC published a paper noting that speculative traders using low-latency strategies deepen market liquidity, and automated traders are able to price securities better and more efficiently than their human counterparts.
Other research has concluded HFT is harmful. Its practitioners are in the business to make money, and because the market is a zero-sum game, other market participants lose money due to HFT. Many HFT transactions nick a little bit off institutional trades, which add up and materially reduce the net return of end-user investors, say HFT detractors.
Financial markets need intermediaries to set prices and manage imbalances. In stocks, this market-making role historically was filled by the specialist, or broker, on the exchange floor. When liquidity or price discovery in a security was limited, the floor broker stepped in and was the offer to the bid and vice versa, and when needed, the person would trade against a natural order.
But floor brokers became an endangered species with the rise of electronic trading as decimalization took hold and spreads narrowed. In 2008, the New York Stock Exchange introduced the Designated Market Maker role. DMMs operate manually and electronically to facilitate price discovery, and they also have obligations to maintain fair and orderly markets in their assigned securities.
Virtu is one of four DMMs on the NYSE, along with GTS, IMC Financial, and Citadel Securities, which purchased KCG’s market maker operations earlier this year. When Barclays relinquished DMM status by selling its business to GTS in January, it was the last of the brand-name investment banks to exit that capacity.
Floor trading represents an important – but diminished – part of the market ecosystem, as only an estimated one-eighth of stock trading transacts on the floor. The lions share of a DMMs business is conducted electronically, and high-frequency trading is a big part of that.
HFT practitioners operate at hyper-fast speeds, underpinned by the latest hardware, software, and transmission technology. They are arguably the most cost-effective financial intermediary that ever existed. Spreads contracted as a result of these trading efficiencies, lowering trading costs – or at least explicit trading costs – for all.
One nuance is that while HFT is perceived as a new phenomenon, the underlying business model of providing liquidity for as many trades as possible, for the purposes of generating revenue, is not new.
New – and Old
HFT has been present in the markets in some way, shape or form for a long time, and its unfair to lump all of the members of the HFT community together, said Peter Maragos, chief executiveofficer of agency broker Dash Financial. Technology companies that have evolved into todays liquidity providers should not be vilified, as they are essential to providing liquidity to both institutional and retail investment communities in a post Dodd-Frank world.
Maragos added that if a firm exists simply to prey on and manipulate other market participants, they should be judiciously policed and scrutinized as regulators have always done. The larger issue, however, is that we need to create a simpler market structure for all investors, whether short- or long-term, which in our view would go a long way towards reducing many of todays perceived issues, Maragos said.
Opinions about high-frequency trading vary widely. But one fact is that the salad days for the methodology are over. HFT makes up about 48-50% of U.S. equity trading, according to Aite Group. Thats down from 60-65% in 2009, back when the field was less crowded and trading profits were easier to come by.
Nobody expects the SEC to attempt to ban high-frequency trading, and while the idea of a transaction tax on high-speed trades recently has been discussed in some political circles, its considered a longshot.
I dont think the SEC is directly going after HFT, said Aites Mindlin. There are benefits to it, and also its very controversial of how do you define HFT, especially HFT versus market making and liquidity provisioning. So theyre treading lightly.
Aside from definitional ambiguity, the SEC is wary of unintended consequences, which in the case of an HFT crackdown most likely would manifest itself in the form of diminished market activity. If they start slowing down or putting the reins around HFT, whos going to come back in to provide liquidity? Mindlin asked.
Rather, the SECs approach seems to be an indirect one, cleaning up around the edges of HFT, and leaving it to market forces to determine the future of HFT.
In April 2016, the SEC approved a rule proposed by the Financial Industry Regulatory Authority that would require algorithmic trading developers to register as securities traders, a move aimed at reducing market manipulation. And then theres Regulation Systems Compliance and Integrity, which the SEC adopted in December 2015 as a way to monitor the security and capabilities of exchanges and alternative trading systems.
Reg SCI to some degree puts market centers on notice that they better know and be able to control the technology and the participants that are leveraging the technology in their marketplace, Mindlin said. They need to be able to know whats going on. Im bracing myself for when the first enforcement action comes against violations of Reg SCI.
IEX, which went live as an exchange on August 19, can potentially damp high-frequency trading as a market factor, if its built-in processing delay of 350 microseconds attracts enough order flow.
Maybe the SEC is indirectly going after HFT with the approval of IEX and its speed bump, Mindlin said. That would be them saying, Were not going to say no to HFT, but were not going to stop market centers from doing what they can to dissipate the effects or potential interaction with HFT.
