Although the conventional wisdom about high-frequency trading has largely been that it makes the markets more liquid and leads to lower trading costs across the board, Pragma Securities contends in a report that HFTs are actually costing investors money.
The firm said it reached that conclusion after studying some of the most highly traded stocks on the market, including shares of Microsoft and Bank of America. The report said that although high volume is usually associated with deep liquidity and cheap, easy trading, the opposite was actually true with those stocks. They were more expensive to trade than their lower volume peers, Pragma said in its report.
"Many ultra-high volume stocks have disproportionately long queues – a result of the huge number of orders competing to provide liquidity compared with the rate at which aggressive orders arrive to take that liquidity," the research note said. "This excessive competition makes it harder for directional traders to successfully provide liquidity, forcing them to cross the spread more frequently and increasing their overall trading costs."
And those costs are steep, with the difference between the highest volume stocks and their more moderate peers amounting to several basis points. Pragma says those basis points add up to an estimated $2.5 billion a year when investors are forced to cross the spread to trade such stocks as MSFT or BAC.
Pragma's research also suggests that the maker-taker model used by exchanges to give transaction rebates to market makers, while charging a fee for customers who take liquidity out of the market, needs to be revamped. The report said those rebates are basically an exchange-driven subsidy for HFTs since they're essential to a good chunk of their profits and are ultimately at the root of the problem.
"By eliminating or limiting rebates for providing liquidity, and reducing the tick size in low-priced stocks above $1 to $0.001, regulators could allow the market to settle on more reasonable spreads in liquid, low-priced stocks and reduce the investor-financed subsidy to HFT market makers and the technology industry that supports them," Pragma said.
And although this could lead to a decrease in trading volumes, Pragma added that directional traders would still have enough counterparties to interact with at a more natural equilibrium.
"The net result would be narrower effective spreads (especially when exchange fees are included), a reduction in profits drawn out to HFTs, and a corresponding net savings for investors," Pragma said.
As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio