September 03, 2009

As spreads tighten and automation has taken over the trading world, the market maker has evolved to meet the new landscape and high frequency trading has resulted, according to Joseph Mecane, Executive Vice President and Chief Administrative Officer for U.S. Markets at NYSE Euronext.

“To a large extent high frequency trading has become market making, says Mecane. He explains that before decimalization and automation the spreads were wider and the markets were slower, making it more profitable to put large amounts of size into the market and the spread would compensate the market maker for that activity.

“But once spreads shrank to a penny and technology was being deployed, the former market maker model wasn’t really profitable any longer and it was difficult for traders to post large amounts of size and make money,” he notes.

“Then traders realized they could post small amounts of size frequency throughout the day and make money,” says Mecane. “But it’s not really possible for a person to do manually so we ended up with automated strategies developing to supply liquidity to the marketplace.”

Mecane says that it is hard to put a number on the percentage of volume that is high frequency trading, but says that internal estimates seem to put the number around at least half of the liquidity in the market coming from automated market making or high frequency trading.

“In general we look at high frequency trading as the evolution of the market making function and as a significant liquidity provider to the market,” says Mecane. “We see their activity as beneficial to the marketplace for the liquidity as well as spread reduction and speed improvements because of the way these types of activities behave.”

Mecane explains that some amount of controversy around high frequency trading developed when there was confusion between flash trading and high frequency trading. “Initially there was some confusion that high frequency trading and flash orders were the same thing but they are very different,” he says. “High frequency trading is more of a general type of trading practice where flash trading is a specific microstructure nuance that we didn’t think was good for the market.”

He adds that regulators have already indicated they will be looking into flash orders and IOIs, along with dark pools and he would be surprised if flash types of trading would be allowed to continue in their current form.

“High frequency trading is just a generic term for a type of computer driven trading strategy, I don’t think there is any way to regulate that,” notes Mecane. “What they can look at is different trading venues or practices that are being utilized.”

He continues that the differences are based on an equal access concept, not speed or technology investment. “The flash concept gives a certain group of traders information before its available to anyone else and market structure needs to be set up where its level and people can get whatever information they would like at the same time,” says Mecane. “People will always choose to make different levels of investment and have different levels of investments.”