Last week's decision by Nasdaq Stock Market and BATS Exchange to suspend the controversial practice of flash orders has caused some of the media and political hysteria to die down. But there is still quite a bit of confusion as to how these flash orders fit into the broader topic of high-frequency trading, and there is debate on whether this form of rapid-fire, in-and-out trading adds value to the equity markets.While everybody is talking about flash orders and high frequency trading, one of the problems is that people are using the terms interchangeably, said Matt Samelson, principal at Woodbine Associates, a capital markets research and consulting firm focusing on equity market structure in Stamford, Conn.
High frequency orders are strategies that are technology-based or algorithms used by sell-side proprietary desk or hedge funds. These strategies seek to gain a very small return on a large number of orders in a particular name or names, according to Samelson's definition. In some cases, the computers are generating thousands of trades based on technical indicators. "Something will tick off the algorithm in terms of price improvement and they'll buy or sell, and they'll do this all day and they're in and out really quick," explained the analyst.
But there are two related issues that get thrown in with high frequency trading: They are collocation - which involves the use of high-powered technology located close to an exchange or ECN to get a speed advantage- and flash orders - which "have become controversial because they create two-tiered markets," said Samelson. Anybody can collocate at an exchange, but if they're getting the information that everyone gets, only faster, are they putting it to use in an unfair way, he questioned. Participants that are members of markets that offer flash orders, get a peak at the order flow before it gets distributed to everybody. "That's another instance where such strategies could have a bit of an unfair advantage," he said.
But flash trading is not the same as high frequency trading, asserts Justin Schack, VP of market structure analysis at institutional agency broker Rosenblatt Securities in New York. "It's probably the most dangerous misconception in the coverage of high frequency trading," said Schack. High-frequency trading has been going on for five or ten years as a result of certain market structure changes, including decimalization and, the 1997 order handling rules - both of which narrowed spreads - and the evolution of competing marketplaces with maker-taker pricing all of which have created the conditions for it to thrive, Schack continued. However, flash orders are "newer to the scene," said Schack. When Rosenblatt did its dark pool report in June, the firm estimated that flash orders were 2.4 percent of consolidated volume. [Only three equity exchanges, Direct Edge, Nasdaq and BATS offered flash orders and now two of them have suspended it while Direct Edge has called off a new flash order initiative.] "It's a tiny portion of what's going on in the overall trading market," observed Schack.
While mostly high frequency trading firms are on the receiving end of flash orders, flash orders pale in comparison to the vast amount of high frequency trading on markets with publicly displayed quotes, says Schack, whose firm estimated two years ago that high frequency traders account for two-thirds of the equity trading volume.
However, there are a lot of people out there who are trying to portray high frequency as the enemy of the institutional investor, noted Schack. While the practice is worth scrutinizing because it's such a high percentage of the volume, Schack doesn't think it's innately evil as some industry folks are saying.
Broadly speaking, there are two different flavors of high frequency trading: Electronic market making or electronic liquidity provision and the other would be statistical arbitrage and various other electronic arbitrage strategies that use high speed trading, explained Schack.
According to his firm, Rosenblatt Securities, the bulk of the high-frequency volume is taking place in the form of electronic liquidity provision, which is seeking to make a two-sided market and earn a little bit of spread and an exchange rebate. "If a bunch of firms are competing to be at the best price, the natural outcome of that is that you are getting tighter spreads," said Schack. Based on transaction cost analysis, implicit costs, which are far larger, than, commissions and fees, should come down because the spreads aren't as wide, he said.
Meanwhile, Woodbine's Samelson believes there's nothing illegal or immoral about high frequency trading, but he doesn't see it as creating value. As far as narrowing spreads and increasing liquidity, Samelson said, "Yeah, it's increased liquidity, but if you're an institutional buyer, if their counterparty is a high frequency strategy, they're getting picked off," he continued. "These high frequency trading firms are extracting value from the positions that investors are taking. It's really increasing trading costs," he contended. While capital markets exist to move capital to the hands of businesses that need it or to let investors have different views on a company and exchange stock, high frequency trading doesn't meet any of these objectives, he charged. "These guys aren't doing anything but taking a piece of their pie and increasing volatility," said Samelson. "Yes, it's narrowing spreads and it's adding liquidity because these firms are buying or selling. But if you're getting the other side of that trade, and you're getting a worse price, so what if you can move in and out of it very easily," said Samelson.
But now that the technological genie is out of the bottle, can the industry really turn back the clock? "The nature of liquidity provision has changed and you have to adjust to that," says Schack. In his view, "high frequency has made the market more efficient and lowered transaction costs. But more efficient - doesn't necessarily mean more democratic," he cautioned. "If you are a high frequency firm and you have a team of super smart programmers and the communications infrastructure, to be the first all the time, of course, you're going to have an advantage over other participants," he said. But that doesn't mean anybody is exploiting an unfair advantage, he added. If another financial firm wanted to make the same investment as the giant high frequency firms, that opportunity is open to them as well. If they don't choose that path, then brokers and other institutions have to be mindful of the market structure and use that to their advantage, advised Schack.Last week's decision by Nasdaq Stock Market and BATS Exchange to suspend flash orders has caused some of the media and political hysteria to die down, but there is still confusion about high frequency trading. 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