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October 14, 2008

At the Speed of Light

Automated Market Makers Alter the Map

By Michael Scotti

Also in this article

Today the United States, tomorrow the world. That's the mantra guiding a group of high-velocity traders-a.k.a. automated market makers-who currently dominate U.S. equities and who are setting their sights on other asset classes and overseas markets.

Right now, this largely unknown, media-shy group of broker-dealers and proprietary trading shops is involved in more than half the trading volume in U.S. equities, according to market participants. Their computer-generated quotes are at the inside market-national best bid, best offer-for every large- and mid-cap stock, sources say.

And their presence is growing, as some estimate their market share could be as high as two-thirds of all trades.

They are to trading what Lamborghinis are to cars: smart, sleek, powerful and fast. Their modus operandi is to use the fastest trading tools on the Street, and to spray the market with millions of orders, with cancels immediately behind them. Besides the gobs of short-term liquidity they provide today in equities, their other contribution is the flickering quote.

"When the human market makers stopped sitting in front of a screen, they were replaced by these automated trading strategies," says Bryan Harkins, head of sales and strategy at Direct Edge ECN, "and the market couldn't exist today without them."

Six People

Others agree. "Algorithmic trading wouldn't work if there weren't automated market makers taking their trades," says Gary Wedbush, executive vice president and head of capital markets at Wedbush Morgan Securities. The firm clears the trades for many of the biggest players in high-velocity trading.

Brian Hyndman, senior vice president at Nasdaq, offers a reason for the increase in automated market making in recent years. A large firm "could make all of its markets with six market makers now, whereas in the past they may have needed 70," he says. "The systems will make the markets that those traders want to make, and they can be more aggressive or less aggressive, but you don't need to monitor each stock constantly during the day."

And the number of new entrants in the U.S. is growing steadily, according to Ted Myerson, president of FTEN, a service provider to prime brokers and hedge funds in the ultra-high-frequency space. Pioneering firms like ATD, GETCO and Tradebot are familiar to followers of the high-frequency trading game. The latter two firms also provided investments to BATS Trading, an ECN-turned-exchange designed for these rapid-trading firms.

But Myerson, whose firm's clients trade 1.5 billion shares each day, points out that the industry includes dozens of other firms that no one has ever heard of. "There are many more firms that don't have a name and won't share it, and you'll never know they are pounding out 100 million or 200 million shares a day in the marketplace," says Myerson, whose firm's business has tripled since January. There's another group doing between 20 million and 50 million shares a day that he expects to near the 100 million mark soon because the business is scalable.