May 03, 2010

While high-frequency trading still raises the buy side's rancor, the reality is that this type of rapid-fire, computer-driven trading has become the main source of liquidity in U.S. stock trading. Institutions may not trust the intentions of proprietary trading firms that employ passive market making strategies, but even the SEC recognizes that the liquidity-providing function they perform is not new.

"Proprietary firms largely have replaced more traditional types of liquidity providers in the equity markets, such as exchange specialists on manual trading floors and OTC market makers that trade directly with customers," the SEC wrote in its recent concept release exploring market structure issues including high-frequency trading, colocation and dark pools.

In fact, in order to survive in a speed-obsessed market structure, the NYSE has had to revamp its specialist model to embrace electronic market making and offer rebates as an incentive to post bids and offers at the NBBO, which has become the basis for matching trades and winning market share. Still, institutional investors remain skeptical about interacting with high-frequency proprietary trading firms, and several voiced their concerns to brokers when they were informed that the NYSE had appointed GETCO, one of the largest HFT firms, to become a designated market maker on the exchange floor.

"The jury is still out for the ultimate investor -- they are hearing a lot of negativity [about high-frequency trading]," observes Joseph Cangemi, managing director and head of equity sales and trading for ConvergEx Group's global electronic trading unit. But, he asserts, "They are also experiencing positive effects of an infrastructure that held up very well [during the financial crisis] and performed under extreme conditions."

So if high-frequency trading is so familiar, and if the market functioned well during the recent financial crisis, why is the buy side still uncomfortable with the high-frequency trading trend? Why are institutions skeptical of proprietary trading firms and hedge funds that use ultrahigh-speed models and networks to profit from miniscule discrepancies in share prices?

One of the reasons that institutions question the value that HFT brings to the market is the lack of hard data available to prove that these strategies help rather than harm long-term investors. While some studies show that HFT reduces spreads on the most liquid stocks (see Woodbine Associates' recent study, for example), what about small- and mid-cap stocks? Do the interests of short-term liquidity providers really align with the rest of the market?

"Indeed, any particular proprietary firm may simultaneously be employing many different strategies, some of which generate a large number of trades and some that do not," continued the SEC. "Conceivably, some of these strategies may benefit market quality and long-term investors and others could be harmful."

The SEC admits that there is a need for clarity on HFT strategies -- which range from passive liquidity and electronic market making to various forms of statistical arbitrage and structural and directional strategies, such as order anticipation and momentum ignition. Further, in response to concerns about colocation, the SEC is looking for comment on the market structure and technology components that enable HFT.

Perhaps to ward off any rash market structure changes -- and certainly to allay investors' fears -- no shortage of firms that engage in high-frequency trading have submitted comment letters to the SEC. Tradeworx, an HFT shop in Redbank, N.J., submitted a letter with in-depth examples of many HFT strategies, including how profits are earned through rebates, according to Manoj Narang, Tradeworx's CEO. But Narang defends HFT firms' role in the markets.

Rebates, he maintains, are necessary to compensate HFT firms for the risks they take. "Most liquid stocks trade at one-cent bid-ask spreads. But in most cases, one cent is not a large enough spread to defray the cost of adverse selection," he explains.

High-frequency trading, Narang argues, is the liquidity backbone of the markets, providing immediacy and fair pricing through statistical arbitrage, whereas the institutions using VWAP algorithms are consuming liquidity as they are accumulating positions, creating a price impact. Pointing out that HFT strategies trade in small sizes and unwind their trades at the end of the day, Narang also refutes the notion that HFT firms add to systemic risk or clog up the exchange order processing pipelines.

Meanwhile, many other prominent HFT firms are stepping out of the shadows and participating more openly in the market structure. Instead of hiding behind their proprietary models, they are becoming more active in defending their automated trading strategies. This will benefit the market's understanding of HFT and perhaps debunk some of the myths that exist.

Even so, as high-frequency, automated market making becomes further embedded in the market, rules and obligations for HFT traders need to be set. Then maybe institutions on the other side of their trades finally will feel more comfortable with it.

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 ...