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Will Regulators Aim to Slow Down High-Frequency Trading in 2011?

Monday, December 06, 2010

By Ivy Schmerken

Why It's Important:
Amid the high-volatility, high-volume trading environment of fall 2008, high-frequency trading accounted for as much as two-thirds of daily U.S. stock trading. Even as volatility and volume have subsided, HFT still generates more than half of the daily market volume, according to Rosenblatt Securities estimates. With the evolution of automated market makers, HFT firms have become the dominant suppliers of liquidity. But high-frequency traders are not required to make two-sided markets, as traditional market makers were required to do. Further, because they spend millions of dollars on technology and colocate their strategies in data centers, HFT firms have access to proprietary data feeds and proximity to exchange matching engines, leading critics, including some politicians, to contend that HFT firms have an unfair technology advantage over long-term investors.

Where the Industry Is Now: The Flash Crash turned up the scrutiny on high-frequency trading. In addition to calls for market maker obligations for HFT firms, head traders from asset management firms have urged regulators to examine the increasing number of order cancelations produced by high-frequency traders. But the final Flash Crash report by the SEC and the Commodity Futures Trading Commission focused on a single buy-side firm's algorithmic trading strategy rather than HFT. "The fact that the Flash Crash report did not point to an HFT smoking gun takes some of the pressure off of high-frequency trading," says Joe Gawronski, president and COO of Rosenblatt Securities.

Still, the SEC is considering tightening market maker obligations on HFT firms, among other new requirements. In November 2010 the SEC banned naked access, preventing unregistered HFT customers from accessing exchanges and alternative trading systems without passing through pre-trade risk controls. And, looking to beef up surveillance of HFT, the SEC also proposed in 2010 a Large Trader Reporting System that would require brokers to tag in real time the trades of firms that execute substantial trading volume.

Focus in 2011: The SEC is focusing on the Dodd-Frank financial reforms, pushing HFT and other market structure proposals to the back burner. "The SEC is not of the mind-set [right now] to totally revamp the market structure," says Gawronski, who notes that SEC policies that favor automated trading paved the way for HFT in the first place. Though industry sources expect there to be some "definition" of market maker obligations for HFT firms, he adds, "We don't expect anything like minimum-time-enforced market maker obligations or colocation bans." Further, in light of the U.S. midterm election results -- with Republicans gaining control of the House, and the Senate's loudest HFT critic, Senator Ted Kaufman (D.-Del.), leaving as planned -- the political climate that saw HFT under attack has changed, Gawronski notes.

Industry Leaders: While the HFT world is secretive, some of the leading firms in the space are GETCO; Automated Trading Desk (ATD), an electronic market maker owned by Citi; Tradebot Systems; RGM Advisors; QuantLabs; DRW; Tower Research Capital; and Tradeworx.

Technology Providers: It's impossible to list every technology that high-frequency traders use, let alone the specialized technology providers, but HFT firms typically rely on direct data feeds from the exchanges, algorithms and proprietary trading models, risk monitoring software, complex event processing engines that look for patterns in data, direct-market-access platforms and smart order routers, colocation facilities at exchange or third-party data centers, servers, and fiber optic networks to reach execution venues at lightening fast speeds.

Price Tag:
Even with the democratization of low-latency technology, there's a difference between the technology used by ultra-low-latency players such as GETCO and Tradebot Systems and smaller firms, according to Gawronski, who says a firm can spend $10,000 a month and achieve fairly low latency. "But the fastest HFT firms," he adds, "are spending tens of millions of dollars per year on their technology and are in a different league."

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