High-frequency trading is here to stay
The 2010 Flash Crash gave high-frequency equities trading a bad name.
Phillip Porado and Sara Tatelman on March 16, 2015
You can just imagine 19th-century blue-blooded jaws dropping when stock traders were said to have started the practice of sending runners across exchange floors to place bids and offers. But that disapproval didn’t stop those traders from practising their wind sprints, or hiring secondary-school track stars (no, really) to do the running for them. Time has always been money.
High-frequency trading is today’s equivalent of racing to the post, and while evidence shows it does unfairly advantage high-income investors, pundits say it’s here to stay.
The latest tech boom to hit Wall St., Bay St. and the City of London has received its share of bad press following the Flash Crash in 2010, triggered by a single large mutual fund firm selling E-Mini S&P 500 contracts. That Flash Crash involved aggressive trading of long futures positions accumulated by HFT traders from the mutual fund— buying and selling large volumes to each other at lightning speeds, and using elaborate algorithms that let them make money on minor pricing changes.
That activity sent the Dow Jones Industrial Average down a staggering thousand points (the second biggest intra-day point decline in the stock market’s history) before recovering several minutes later.
The ensuing media fallout spawned a book—Flash Boys, by Michael Lewis— which further demonized HFTs, though it did little to change views among the professionals. There were also increasing calls for more regulation of securities trading and heaps of research devoted to ways trading could be slowed. Yet the hubbub overlooked one of the fundamental duties of a broker to his or her clients: best execution.
Simply put, a customer who isn’t up to anything illegal is always right. And it falls to the broker to ensure a client order to buy or sell a stock is executed at either the best possible price, within the shortest possible time frame, or with sufficient anonymity to ensure the trade doesn’t cause the price to move before the transaction is complete. Which of those three things takes priority is the prerogative of the client, not the broker.
Efforts to meet that duty have always driven brokers to adopt new technologies, starting with telecommunications starting in the late 1800s, moving to sophisticated quote montages that allow traders to see far more customer bids and offers to buy and sell in the 1980s and ’90s and, most recently, HFT (which replaces traditional copper phone lines with fiber optics, microwave relays, and other gimmicks to shorten the time it takes to bring order to market and transact business).
Interestingly, the Internet’s speeding up the rate at which information reaches investors led the third execution priority —anonymity—to become more important early in the 21st century. With news travelling faster, more people were able to catch wind of reports about factors that might impact a stock’s price.
Worse, they could catch wind of when a rainmaker with large blocks of shares in a troubled company was unloading his holdings. So a desire to keep trades quiet spawned specialized trading venues, called dark pools, where anonymity was king. Designed to connect with the fastest of off-exchange markets, they were tailor-made for high frequency traders.
Those without access to the fastest and the best, of course view the trading practices as problematic. And a lot of the algorithm trading arguably short-circuits the original purpose of the capital markets, which is to bring funds to companies that need them to bring goods to market and to grow.
And then there’s quote stuffing, a process by which traders plug millions of bids and offers into a trading system, only to cancel them moments later.
The practice is meant to distract other market participants by adding extraneous information to the data flow and making it difficult to arrive at sound trading decisions.
A December 2012 study by the Investment Industry Regulatory Organization of Canada revealed that high-order-to-trade traders accounted for only 22 percent of total share volume traded in Canada, but 94 percent of high-order-to-trade messages.
HFT has gotten a bad rap for edging smaller investors—the ones without funds to pay for super-fast trades—out of the markets.
“The losers are probably the traditional brokers, the people who used to make a killing,” says Ryan Riordan, a business professor at Queen’s University who has conducted extensive research on HFT. “They used to supply the liquidity. Now HFT is taking the easiest part of their business.”
And, he says, the costs of the technology are also a barrier to its wider adoption. In the end, changes wrought to the landscape of available dealers and brokers create more change within the Canadian marketplace than a momentary flash crash.
Jos Schmitt, president of alternative market Aequitas, agrees HFT has taken a toll on the market. “The key issue is that HFTs provide liquidity to already liquid securities, crowding out traditional market makers. This, combined with predatory HFT, leads dealers, investors and companies to lose confidence in the market.”
Kevin Sampson, TMX vice-president, business development and strategy, concedes that lost confidence in the market is a big concern, but doesn’t blame HFT for the 2010 Flash Crash. “It’s been shown through studies that have been done in the U.S. that it wasn’t predominantly HF traders that caused the flash crash…. But it goes back to the perception,” says Sampson. “The investor just gets this feeling that something doesn’t look right or isn’t functioning properly. That influences the degree to which they participate in the markets.
“That’s why it’s incumbent [on]… all market participants to educate people.
We need to make sure we’re talking facts versus myths or fear-mongering.” In fact, many market observers point to what they call a more disturbing practice in which some think tanks and universities were selling HF traders early access to consumer surveys and other information. Outcry against the practice, which was said to give traders with ultra-fast access an edge in the markets, resulted in the New York attorney general’s office asking Thomson Reuters to cease selling University of Michigan consumer survey results to HF traders two seconds before the information became publicly available.
Mark Yamada, president of PUR Investing Inc., doesn’t object to HFT, but does welcome Thomson Reuters’ change in policy.
“The principle of fair and equal disclosure should apply. To do otherwise is like selling inside information. If Thomson Reuters makes all data available to everyone at the same time, it’s difficult to object.”
Despite rebate arbitrage in which some HF traders buy and sell stock at the same price to profit from maker-taker pricing, HFT as a whole provides valuable liquidity to the marketplace. “We see benefits to the market in the form of reduced spreads,” says Sampson.
“Ultimately, investors are getting better prices. Our markets are probably as efficient, or more efficient, now than they have ever been.” He adds that customers must sometimes pay higher costs because of HF trading activity, but those challenges will always exist. Further, notes Riordan, “We have no evidence HFTs destabilize the market.”
His research also reveals HFTs are good for providing liquidity to the markets—generally speaking. HFTs tend to narrow the bid-ask spread by ensuring the market makers are protected from price fluctuations. This in turn lowers trading costs, except when HFTs short sell.
“We found they’re great for liquidity when you’re submitting the order,” he says. “When you stop submitting the order, liquidity shuts off.”
With practices like quote stuffing and selling early access to information, it’s no surprise traders on both sides of the border are looking for ways to make HFT fairer. Some have suggested a sort of electronic speed bump will level the playing field among traders.
Further, those concerned about HFTs catering to anonymous traders, have offered suggestions for lighting up the so-called dark pools in which those wishing to buy or sell large blocks of stock away from the prying eyes of major market quote montages have chose to transact.
Some investment exchanges in Canada and the U.S. have gone another route: creating their own trading systems bound by strict rules and higher fees. IEX, an American-registered broker-dealer is an alternative trading system funded exclusively by a group of mutual funds, hedge funds, family offices and individuals. It functions as a subscription-based platform.
Founded by Markham, Ont. native Brad Katsuyama, IEX has created an infrastructure aimed at protecting orders from predatory trading, “a sub-class of high frequency trading, that attempts to identify and disadvantage traditional investor order flow,” its website states.
“Despite the reputation that HFT has garnered, there are many HFT strategies, which provide a valuable service to the market. Predatory trading is not one of them … and our plan is to stop it.”
With the launch of Aequitas Innovations, the new exchange whose name means “evenness” and with the stated aim “to address the pressing market issues of fairness, liquidity and transparency impacting investor confidence,” Canadian investors will have another alternative. The Ontario Securities Commission gave the green light for trading to commence March 1.
On balance, says Yamada, the market does a good job of managing price discrepancy.
“To me, HFT is just a more advanced technological form of that,” he says. “It can be abused a little bit but as I say, on balance, it arbitrages away the discrepancies between markets. A level playing field is a good thing. Let the stronger survive, let the weaker die. It’s a jungle out there. I think regulators and suppliers have to maintain that same principle of fair and equal treatment.”
With files from Dean DiSpalatro, Jessica Bruno, Katie Keir and Anna Sharratt
Copyright 2014 Rogers Publishing Ltd. This article first appeared in the March 2015 edition of Corporate Risk Canada magazine