Commentary

Tim Quast
Traders Magazine Online News

We're All HFTs Now

In this guest commentary, author Tim Quast looks back at the history of HFT and how the market has evolved to where many firms now fit the definition of high-frequency trader.

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April 30, 2000

Cover Story: The Next wave

By John A. Byrne

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  • Cover Story: The Next wave

A frightening thought must strike executives at market making firms when the Nasdaq Composite Index hits skid row: What good is the best military-style planning if the sun finally sets on the longest-running OTC party in history?

Military-style planning is the most striking feature of the current Nasdaq market making scene. Nasdaq trading firms, especially the largest, are implementing plans for a future based on an assumption that Nasdaq will still keep growing.

They are planning for a future in which retail order flow on some of the most actively traded stocks can be parlayed into successful block trades; a future in which an expanded universe of stocks is the magic formula for a firm that wants to internalize orders and optimize profit opportunities; a future in which Nasdaq has a shot at brushing aside the encroaching electronic communications networks and becoming, de facto, the largest ECN itself; a future in which institutional investors may get what some buy-side traders have demanded: a mandatory central limit order book with price and time priority.

Grandiose Vision

The biggest change will occur if Nasdaq can execute the grandiose vision of itself as a global market, trading stocks 24 hours a day across multiple time zones. Nasdaq has agreements with international partners and has talked hopefully about the quantum leaps in volume that could result. But the results are pending.

If the markets enter prolonged bear territory, however, the wave of change underpinning the structural shifts in the OTC markets may never occur. Indeed, it is reasonable to assume that the structures could evolve into a model driven more by conventional spread-based dealer business. Experts would probably look back too and wonder what pushed so many momentum investors over the cliff.

Nonetheless, dealers do not have crystal balls. They live in the present. That means planning yes, military-style planning. The annual Market Maker Survey conducted by Traders Magazine, spells it out: internalization of order flow is the number one topic. "Internalization is going to be the hottest industry issue in the coming year," said James Toes, director of Nasdaq trading at Merrill Lynch & Co.

Merrill is formulating its own aggressive plans to make markets in more stocks, going from 550 to 2000. The firm is even planning to transfer its current desk to a site somewhere in New Jersey. The site will be outfitted with advanced technology.

The survey, for 12 months ending March 31, 2000, was sent to the top 100 market makers as ranked by AutEx/BlockDATA, a service of Thomson Financial. The survey also used other industry measurements for the final list. A total of 41 market makers responded.

Profit Motivation

Internalization certainly stands out. The reason: In many cases it is more profitable trading the same OTC stocks on a principal instead of an agency arrangement, said Bernard Madoff, president at Bernard L. Madoff Investment Securities. (The survey shows that 62 percent of dealers saw an increase in profit margins per trade but that reflects institutional as well as retail trades.) Said Madoff, "More firms want to get a piece of the increased Nasdaq trading volume." As lower transaction costs fuel bare-bone retail commission rates from online discount brokerages, agency orders have become less attractive.