November 26, 2011

Although high-frequency trading often is credited for improving the marketplace for all participants by adding liquidity and lowering spreads, a large swath of the buy side remains uncomfortable with HFT's growing influence. Most institutional traders, who generally trade on behalf of large clients such as pension funds and endowments, acknowledge that all high-frequency traders -- and their order flow -- are not created equally.


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On one hand, there are high-frequency market makers such as Tradebot Systems or Getco, which execute millions of shares a day and ultimately make it easier for traders of all stripes to get in and out of positions. But on the flip side are smaller high-speed shops that deploy powerful computers to hunt down imbalances in supply and demand, predict which direction the markets will move, and subsequently beat slower-moving traders to the punch. Often, buy-side desks pay more for stocks or earn less on sales than they could have had it not been for the presence of high-speed order flow.

According to Rob Hegarty, the head of global market structure at Thomson Reuters, buy-side firms that deploy long-term, low-turnover investment strategies tend to have a more negative view of high-frequency trading, as do firms that employ quantitative, algorithmic-based strategies, since their tactics often go head-to-head with high-speed traders. But that view isn't universal throughout the industry, Hegarty notes.

Tucked between the long-only players and firms that rely on quant-focused strategies are mid-tier money managers that opt for the algorithmic or program-driven techniques offered by their brokers. "When you look at the brokers that are providing that kind of service to the buy side, they're definitely feeling it with the high-frequency folks. But at the same time some of those high-frequency firms are their clients," Hegarty says.

"There are definitely buy-side firms that are concerned about high- frequency trading being predatory and basically sucking liquidity out as opposed to providing it," Hegarty adds. "But there's a whole cadre of firms with the view that if it weren't for HFT, there would be no liquidity."

Still, a survey published in September by Liquidnet, which allows institutional traders to trade large blocks of stock anonymously, indicates that most buy-side firms indeed hold a negative view of high-frequency trading. In a poll of 630 institutional managers who collectively handle more than $13 trillion in equity assets, nearly two-thirds said they were concerned about the impact of high-frequency trading on their performance.

HFT Gains 'Momentum'

The buy side is concerned about managing transaction costs and preventing information leakage in a landscape dominated by high-frequency trading, Liquidnet CEO Seth Merrin says. According to Tabb Group and Aite Group estimates, high-frequency trading accounts for nearly 75 percent of the daily volume traded in the equity markets.

"It's only been recently that high-frequency trading has been a majority of the volume," Merrin notes. "In its growing stages -- when high-frequency really only consisted of statistical arbitrage-type trading or rebate trading -- it wasn't much of a concern. The concern comes from the strategy they're deploying now, the momentum strategy." In the momentum technique, high-frequency traders manage to detect large orders from institutions before they're executed, explains Merrin, who likens it to old-fashioned front-running, in which an unscrupulous sales trader tips off clients (or even the prop desk) about an impending block order, allowing them to trade ahead of the order.

Traditionally, however, front-running benefitted "one or two buyers out there that would trade ahead of that institution," Merrin says. "Today you've got a whole class of high-frequency traders with very high-powered computers, with billions of dollars at their disposal, that is essentially doing the same thing. And it's not illegal."

In order to avoid tipping their hands, sources say, the buy side typically tries to disguise orders by trading through multiple prime brokers, cutting down large orders into smaller pieces and/or executing through a variety of algorithms provided by different brokers. "There's a number of different strategies they use to hide their footprints in the market," Thomson Reuters' Hegarty says, noting that firms also are turning to block-focused dark pools such as Liquidnet or ITG's Posit.

Despite these techniques, however, the buy side still is challenged to disguise order flow in the new environment, argues Harrell Smith, the head of product strategy at trading system provider Portware. "For a lot of these guys it's a relatively new phenomenon, and right now they're kind of in the intelligence-gathering stage."

ABOUT THE AUTHOR
As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced ...