There is more to life than increasing its speed.
–Mahatma Gandhi
by Matthew Weber | Director of Trading + Operations
Even though we are “investors,” we are very aware of the High Frequency Trading (HFT) issues that emerge on our playing field. While the portfolio management team at CSC might profess not to care about a penny here and a penny there when they are looking for 50% and 100% moves over time (and that IS the correct big picture), it’s my job to pick up the pennies for our clients, or at least defend our wallets from the unrelenting pressure of HFT.
Having been a student of market structure ever since the creation of many market venues, algorithms, dark pools, and HFT, I believe that the majority of HFT is benign with regard to our day to day trading and in many cases the liquidity provided can be beneficial to our clients. There are predatory HFT firms and strategies that exist, but it is important to remember that “financial predators” have existed since investors met under a tree at Wall and Broad. So it’s not just the Lehman and Goldman block trading desks looking to scalp our clients, it is a new breed.
It is very important that any trader understands every electronic route they are using and how all players in the market are interacting in that space. It is also important to understand that there are tools outside of the electronic marketplaces including Alternate Trading Systems (ATS) such as Liquidnet that provide buy side to buy side liquidity. In addition to ATS, some firms are rediscovering the idea of “upstairs” trading using the age old method of phones, relationships, and high touch trading in order to create liquidity.
For many years the sign of a great trader was being able to identify when a predatory HFT had corrupted an algorithm that they were participating in and adjust on the fly. Today a great trader understands the market structure in which they exist and takes efforts, pre-trade, to avoid being captured in the first place. I am very active in my peer community keeping up on the latest trends and developments in electronic market structure. In the new book Flash Boys by Michael Lewis, we hear so much about how “fast” an HFT is and how they can make fractions of pennies in a millisecond based solely on their superior speed. However, the largest risk for a small cap order exists when you are routing with inappropriate order types, algos, or exchanges. If one does not understand what the HFT are looking for, it is very easy to leave a trail of “tag data” that can give away the larger picture of what you are trying to do. Picture this: most of the earlier HFT of the 70’s and 80’s acted as market efficiency police. They found stocks trading on the tail of a bell curve, outside of their fair value band, and made their money normalizing them back in. Compare that to the HFT of today that will instead push and push you further down the tail, creating more and more market inefficiency, and know exactly when you will finally break and give in to the new price they set. Although a great trader can take many steps to avoid predatory HFT, he/she still needs to still be able to identify when something has gone wrong and a trade has moved outside of a fair value band for no other reason then inefficiencies due to the “business” of trading.
The HFT chatter over the past few weeks has been excessive, but it is creating this necessary dialogue. The truth is HFT has existed since the beginning of markets; in the Buttonwood Agreement (May 17, 1792) itself there is a line that states the group would give preference to themselves. As years went on and ticker tape technology was the big thing, the senior partners sat right at the machine and the junior partners all the way at the end of the tape. Speed and preferential routing order types have always been an obstacle, but something new has always come along and made a new group of traders have an “edge”. Lets again point out I used the term “traders” and not “investors.” My concern with the current focus on HFT is that it comes at the end of their technological edge. Speed has become a commodity as we have reached the height of speed that physics will allow and these lines are no longer cost prohibitive. I believe that the age of latency arbitrage strategies that the HFT employ is evolving into a more predictive technology. Along with not necessarily having a speed advantage, this new attention they are getting will hopefully start to eliminate some of the beneficial order types they enjoy on some of the exchanges. Another helpful step would be to start defragmenting the marketplace. There are too many exchanges, routs, order types, algos, etc.
Is HFT evil, and what exactly have they been doing to us? In simple terms, we as an industry over-built exchange options and fragmented the market. Orders that once were worked as a single block and sent to one or two exchanges now have to be split up and represented in sometimes as many as 30 different locations. We wait and see where success is being had and try to re-route the balance of the order there. HFT recognized this workflow and took advantage of a situation beating us to where the liquidity was. Making matters worse, at the same time that multiple exchanges were popping up, the market went from fractions to single penny pricing, reducing the risk to HFT significantly. This fragmentation resulted in an average trade size of 300 shares creating an environment of very low block trading or wholesale liquidity to the true investors. This development created such a frustration in the investment community that I believe we are close to the turning point for investors like us to get our markets back. Alternate Trading Systems will continue to gain traction providing wholesale execution on a peer to peer basis as well as the proven results of high touch brokers with phones and relationships. With our orders being exposed less and less to potential predatory HFT it will leave them no choice but to reinvent their business model.
