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Seth Merrin Examines the Pros and Cons of High Frequency Trading

High frequency trading adds a lot of liquidity, but institutions need to opt-in to that, says Liquidnet's Seth Merrin.

While industry analysts have said that high frequency trading is the next evolution of market making and adds liquidity to the equity markets and has narrowed spreads, Merrin said he would not put high frequency traders in the same category as market makers. He offered the example of Nasdaq having 4,000 listed securities, but ECNs are effective in the top 300 names. Still, the industry needs market makers in the bottom 3,700 names, he said. “High frequency trading is primarily in the largest most liquid names. What we need is capital provided in the least liquid names. They can’t make money in the least liquid names. So are they providing the same services to the market as market makers?” asked Merrin. “The answer is no,” he asserted.

Additionally, high frequency traders are not subject to the same regulatory structure and rules where they are required to make markets. “They go where the liquidity is and the opportunity is and they leave where the opportunity is not,” said Merrin.

On the topic of regulation, Merrin said, he didn’t know how to regulate high frequency trading. “The problem is that two years ago, this wasn’t a big issue and today it’s a big issue. Two years from now, I don’t know if it will be an issue, ” said Merrin. But he also pointed out, in the time it takes the SEC to understand the ramifications of the trading and changes in the market structure, they could create regulations and put them out for comment, and by the time they enact the rules, there could be an entirely different problem. “What we need is transparency in the market. Our constituency —the buy-side —needs to understand what’s happening and that’s an educational process,” said Merrin.

Despite his negative opinion of flash orders, Merrin said he abhorred the fact that a senator (Sen. Charles Schumer) could stand before the media and threaten the SEC to ban the practice, since this jeopardizes the value of an independent SEC that maintains a system of checks and balances. While in this case, the senator happened to be correct, the next politician could be entirely wrong, warned Merrin.

As regulators examine some of the changes in market structure, Merrin said what he’s afraid of is that they could say to get rid of dark pools, without understanding the benefits of dark pools. “Our job is to create a safe environment for the institutions,” said Merrin, who operates the largest institutional pool of liquidity for buy-side institutions to trade anonymously to reduce market impact. Having one central pool of liquidity where everyone has to go and trade, is not conducive because there are too many competing interests in one location, he insisted, adding that’s why there is a need for alternatives.

“Now, high frequency trading can provide a lot of liquidity to institutions, but Merrin said they need to “opt-in” to that. “So again, (high frequency trading is) not all bad,” he said. But it can be detrimental if institutions don’t know they are interacting with high-frequency flow and what this high-speed flow can evolve into. “The more money that’s chasing this high frequency trading, the more they’re going to have to do it at the expense of somebody else, and I’m just afraid that expense seems to always come out of the institution’s pocket,” said Merrin.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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