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Some Consider High-Frequency Trading to Be the Dark Side of the Trading World

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Some Consider High-Frequency Trading to Be the Dark Side of the Trading World HFT Some consider high-frequency trading to be the dark side of the trading world. But are things really that black and white? Dan Barnes investigates. Flash crash saw a discussion about high-frequency trading book that the market “is rigged” in favour of a (HFT) on Good Morning America,” says specific HFT strategy, latency arbitrage. Mark Goodman, head of quantitative Latency arbitrage makes money in an aggressive electronic services for Europe at broker Société manner from buyside orders; they can only exist in Générale. “When the debate gets to that level, symbiosis. Buyside orders for large blocks of securities “Iclearly it is has moved away from an industry take a long time to fill and traders are careful not to discussion on the nuances of finding the right type of reveal their positions as they are executing their liquidity, and towards representing a very black and trades, in case the market moves against them. white picture to the public. Whether it is for better or In the US, orders must be routed to every exchange worse I don’t have an opinion, but with a debate at to find which has the best price, according to market that level I can see that legislation could be brought in rules. The route taken is predictable. Latency to regulate HFT.” arbitrage firms place lots of orders on exchanges, The trigger for a discussion about HFT on a which they cancel before they are filled. Thus, when breakfast television show, was the book ‘Flash Boys’ they get a hit from a big buyside order they can by Michael Lewis, released on March 31st 2014. establish its price and size without committing to fill Lewis’s book follows the creation of the IEX trading the order. As they know which route the order will platform, aimed at helping asset managers avoid HFT take to circulate around the exchanges, they leap order flow. IEX ceo Brad Katsuyama asserts in the ahead of it using high-speed connections, playing that Summer 2014 21 unwanted middle-man role at very high speed. trading at buyside firm Invesco, said: “While By placing bids or offers, HFT firms can also Invesco believes there are many beneficial high- move the price of a security up or down, then frequency trading strategies and participants which withdraw the orders in microseconds and switch provide valuable liquidity and efficiencies to the sides to buy or sell at an artificially high/low markets, we also believe there are some strategies price. On April 4 2014, Joseph Dondero, that could be considered as improper or co-founder of the firm Visionary Trading, was manipulative activity.” barred from market trading and fined $1.9 Methods of avoiding unwanted middle-men are million by the Securities and Exchange long-established. Firms can trade over-the-counter Commission (SEC) for placing and cancelling (OTC) directly with other firms to avoid showing layers of orders. This had created fluctuations in their hand. Markets that do not disclose order the national best bid or offer of a stock, information pretrade called dark pools, facilitate increased order book depth, and used non-bona fide concealment from aggressive trading. These can be orders to send false signals to other market run by broker-dealers and HFT firms themselves participants, according to the SEC. e.g., Chi-X Global or stock exchange operators. Some, like OTC market Liquidnet, use a broker- Previous warnings dealer licence to provide matching services without These strategies are nothing new. Chris Marsh, head trading on their own book. Liquidnet, which only of alternative execution services at broker Credit matches up buyside block trades, was launched in Suisse, warned of predatory electronic trading firms 2001 in the US and now covers 43 markets. By placing fake orders in the October 2005 edition of crossing large block trades for buyside firms it has The Banker magazine. The market regulation that specifically been designed to avoid the risks of requires the routing of US orders, Reg NMS, which aggressive trading and information leakage. Others enabled latency arbitrage to be effective has been in match the orders that a broker receives from two force since 2007. Market regulators in Europe and the clients internally within the client. US have been publicly discussing fake orders since IEX launched in October 2013, and ensures that Simo Puhakka, chief executive 2009. client orders are routed to all other US markets with a officer at Pohjola Asset Management Execution Services and Saurabh Buyside traders have also long been aware of the time delay to prevent latency arbitrage firms from Srivastava, global head of electronic issues and vocal in their concern. In a taking advantage of them. trading at Invesco representation to the Joint CFTC-SEC Advisory Given the established nature of the debate and the Committee on Emerging Regulatory Issues on avoidance tactics, it may seem surprising that the August 11 2010, Kevin Cronin, global head of publication of Flash Boys coincided with 22 Summer 2014 HFT A sustained period of trading for months without making a loss is statistically improbable, but many proprietary HFT firms pull it off for even longer. investigations into HFT trading practices by the advantage over other traders. It Federal Bureau of Investigation and the SEC. is this that the authorities are investigating. As both brokers and Unfair manipulation? exchanges are shareholder-led, for- What they are investigating are unfair practices. The profit entities, paid according to the original question that aroused Lewis’s interest was volume of trading they process, support for HFT whether firms, brokers or otherwise, could manipulate is hardly surprising, says Saurabh Srivastava, global markets unfairly using HFT technology. During the head of electronic trading at Invesco. 2009 prosecution of a former Goldman Sachs “We shouldn’t be surprised that the market works programmer for allegedly stealing code, a government the way it does, when the principles of the market are prosecutor said: “The bank has raised a possibility revenue maximisation,” he says. that there is a danger that somebody who knew how “[Lewis’s book] made the point that broker-dealers to use this program could use it to manipulate are conflicted, and buyside investors should markets in unfair ways.” understand that broker-dealers don’t necessarily have That struck a chord with Lewis, as nine months their best interests at heart because they exist to make prior to the programmer’s conviction in December money. Every broker will manage the conflict of 2010, later ruled wrongful, Goldman Sachs traded for interests that exist in different ways. As a buyside 63 days without losing a penny; in fact in Q1 2010 it trader you better pay attention to this, to understand made more than $25 million every day in revenue and where your broker routes your orders, to measure over $100 million for more than half of those days. A their performance.” sustained period of trading for months without A further concern is that in the US the market making a loss is statistically improbable, but many infrastructure actively provides advantages to high- Mark Goodman, head of quantitative proprietary HFT firms pull it off for even longer. speed traders. It allows them to access data at a higher electronic services Virtu, a major HFT player, only faced a trading loss speed than is provided for regular traders through for Europe at Societe on one day in four years of trading, according to its feeds mandated by regulators (the Securities Generale 2014 IPO prospectus. Information Processor or ‘SIP’) of which there are As the law of averages is tamper-proof, the only two for equities managed by exchange operators explanation was that the rules of the game did not NYSE Group and Nasdaq OMX. expose HFT firms to the same risks that other firms “There is a two-tiered market, with the SIP and the faced when they traded. direct data feed,” says Srivastava. “The fundamental The next question was whether brokers and exchanges question is why do we need two market data feeds? were supporting HFT activity, enabling it to gain an Shouldn’t everybody in the world operate off the same Summer 2014 23 HFT (TCA) by the buyside of execution data, says The markets as they exist today do not serve Rebecca Healey, senior analyst at Tabb Group. TCA takes feedback information on trade executions to the interests of long-term investors, who are the determine how performance was affected by the brokers, strategies and venues that were used. cornerstone of the capital formation process. “In Europe, the buyside has had to invest in TCA to a greater degree to demonstrate best execution to their underlying clients,” she says. “FIX tags are enabling the market data feed? That needs to be addressed.” buyside to better interrogate the information that a The threat of increased trading costs from latency broker is giving back to them, around Tag 29 (whether arbitrage is not a US-only phenomenon. In Europe, the broker’s capacity was as an agent or principal), Tag the monopoly of national exchanges was removed in 30 (on which venue an order was filled) and Tag 851 2007 under the Markets in Financial Instruments (whether the broker engaged in maker-taker activity). Directive (MiFID) and created a fragmented Firms are trying to understand how the broker had market similar to the US. Without the regulatory behaved in the market place and whether that had imperative to route orders, the obligation to provide impacted execution performance.” best execution falls upon the asset manager’s broker, under a best-execution agreement. Sellside firms Dark pools provide the smart-order routers (SORs) that are Pohjola Asset Management Execution Services began intended to find the best execution point for their developing a buyside operated SOR four years ago, in clients.
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