Media Room

US: High frequency trading dominates the debate

Tuesday, October 20, 2009

By Michael Mackenzie

Equity trading volumes in the US are now dominated by traders using powerful computer algorithms in a practice known as high frequency trading.

Concerns in some quarters that HFT could have a disproportionate influence on markets have made it part of a broad inquiry into the structure of the US equity market by the Securities and Exchange Commission. The practice is also growing rapidly in Canada and Europe.

High frequency traders seek to extract tiny amounts of money by placing massive orders in the form of small parcels of trades on electronic exchanges at the NYSE Euronext and Nasdaq OMX, BATS Exchange and Direct Edge, the main trading platforms for US listed stocks.

The rise of high frequency trading reflects the big changes that have swept through the US equity market during the past decade. Before the changes, market-makers shouted orders across the trading floor and quoted prices with a difference of at least 1/8th of a dollar between buying and selling shares.

“In today’s highly electronic trading environment, high frequency trading firms play the role of liquidity providers, very much like the traditional market-makers and specialists of the past, just without the perception of conflict of interest and information advantage,” says Sang Lee, managing partner at Aite Group.

The move to quoting stock prices in cents, not fractions in 2001, broke the back of the old market-making system. Providers of liquidity were unwilling to quote prices for large orders, as the quoted difference or spread between buying and selling shares shrank. The size of the average trade is 250 shares, down from more than 1,000 units a decade ago.

In turn, the rise of alternative trading platforms fragmented liquidity and prompted a turf battle with exchanges that paid market-makers a rebate to provide prices.

By 2007, high frequency trading was surging, after a ruling by the SEC allowed firms to trade NYSE-listed shares across all other market venues.

Against this backdrop, computer systems that can break down a large order into tiny slices and execute them across different trading venues at close to the speed of light has become the new way of doing business in the US equity market.

The main objective of high frequency traders involves minimising risk and posting small deal sizes that enable them to move in and out of trades extremely quickly, arbitraging between spreads available on different exchanges and platforms, and even between the speed of trading available on them.

As a result, they often turn over their portfolio of shares many times during the day, capturing revenues of between one-10th and two-10ths of a penny for each share traded.

“High frequency traders need to trade massive volumes to make their strategies sufficiently profitable,” says a report written by Justin Schack and Joe Gawronski of Rosenblatt Securities.

Among the most common strategies are: being automated market-makers; deploying a predictive approach, whereby certain changes in stocks trigger an order; and pursuing arbitrage, seeking to buy and sell shares at a profit across different platforms.

The speed factor in trading is known as latency and requires constant upgrading of computer systems to stay ahead of the pack. Exchanges also provide space at their data centres for computer servers owned by high frequency traders. This “co-location” means a high frequency trading system can access prices a fraction faster than if it were located down the street, let alone in another city.

“In today’s trading environment, a significant percentage of human traders has been replaced by emotionless computers,” says Mr Lee. “For active traders, anything more than a millisecond has become unacceptable.”

By moving share trading out of the hands of floor traders, who had an inside look at order flows, advocates of electronic systems say it has become fairer. They also argue that high frequency trading keeps buy and sell prices close together, which benefits all investors.

It is estimated that high frequency trading accounts for as much as 70 per cent of daily US share trading, up from about 30 per cent a few years ago.

Among the largest of the traders are hedge funds Citadel Investment Group, DE Shaw & Co. and Renaissance Technologies. Meanwhile, automated brokerages including Getco, Hudson River Trading, Wolverine Trading and RGM Advisors are active.

At a recent panel discussion in New York, held by Aite Group, Richard Gorelick, chief operating officer at RGM Advisors, said it was incumbent on the industry to participate in the debate over high frequency trading and get out and explain what it does.

“HFT firms are making real profits on real trading,” says the Rosenblatt report. “They are not pouring dollars into assets whose value is being wildly overinflated because of largely psychological or otherwise artificial reasons.”

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