December 01, 2009

Little has caused as much consternation recently as the growth of high frequency trading (HFT) and dark pools. An oft-repeated statistic is that high frequency trading now represents 70 percent of the reported volume in the U.S.

HFT firms use automated strategies that use speed to gain very short-term advantages over other market participants while maximizing the rebates offered by market centers for liquidity providers.

Virtually all venues pay people to post bids and offers and charge people to remove liquidity. These economics are at least partially responsible for the unprecedentedly tight spreads investors now enjoy.

Whether by design or as a consequence of the HFT firm’s aggregate strategy, HFT traders now effectively perform the same function as the market makers and specialist of yesterday. In most cases they do this better, faster and cheaper than the market makers and specialists did.

Since the older model was based on human intervention, it was much better at stopping erroneous trades. For example, if the market for IBM on the NYSE floor was 127 bid and 127 ¼ offered and someone sent a sell order at 27 for 250,000, the specialist would reject the order as nonsensical.

In today’s automated world the machines pass no such judgment and will fill orders all way down to the specified limit. FINRA and the venues themselves have rules for dealing with "clearly erroneous" trades but they are typically not triggered until the stock moves more than 5 percent.

Predatory participants purposely float bids and offers just inside the erroneous limits in an effort to profit from the occasional "fumble finger."

HFT firms, market makers and NYSE specialists all share the same desire to make profits. While the latter two were highly regulated the former are not. Since the unregulated HFT firms are in effect acting like unregulated market makers, institutional investors need to take special care as they transact in size.

One reasonable trading tactic is to avoid the HFT-rich venues and seek liquidity in the so called "dark pools" which cater exclusively to institutional investors. Venues such as BlockCross, Liquidnet and Pipeline neutralize the HFT risk by screening their client base and enforcing high minimum order sizes.

Further, such systems are able to scan the order management systems of their customers for the purpose of matching trades and avoiding markets dominated by HFT firms all together.

In the final analysis, HFT firms are inherently no better or worse than other market participants, they are just different. The retail investor is a net winner as spreads are much tighter. Institutional investors need to adjust their trading strategies accordingly.

About the Author

J Mark Enriquez is Managing Partner at Pulse Trading. Previously, Enriquez was a Senior Vice President and Director of Electronic Trading at State Street Brokerage. Before that, he was a partner and Manager of Business Development for the MacGregor Group where he was responsible for new product development in the areas of trading and management systems. Prior to MacGregor, he was a Senior Systems Consultant for the Putnam Companies where he developed risk analysis and derivatives trading models.