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November 11, 2008

High-Frequency Traders Flee

By Nina Mehta

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  • High-Frequency Traders Flee
  • Page 2

Some market volume was missing in action in September and early October. The Securities and Exchange Commission's temporary emergency ban on short sales in financial stocks chased liquidity out of the market, according to several broker-dealers.

In the two weeks following the ban, trading volume was high by historical standards, but some think it was suppressed by the emergency prohibition on short selling that went into effect on Friday, Sept. 19. "The high-frequency players are turned off right now because of the SEC ban on short selling in financial stocks," Dan Mathisson, head of Advanced Execution Services at Credit Suisse, said the week after the ban was announced. "On days like these, with so much news on the tape, I'd have thought we'd see 13 billion or 14 billion shares." Mathisson and the others in this story spoke at a Traders Magazine conference in late September.

Consolidated equity volume hit all-time daily records in the two days prior to the ban, reaching 18.7 billion shares on Sept. 18. Volume was just under 16 billion on the 19th, when the ban was implemented. Trading volume fell to 8.8 billion shares the following Monday and Tuesday, and ranged from 8 billion to 9.4 billion shares the rest of the week. Average daily volume in the first half of the year was under 8 billion shares, compared with 5.8 billion shares in the year-earlier period.

Joe Gawronski, president and chief operating officer at Rosenblatt Securities, estimated that high-frequency trading in the months preceding the ban represented half to two-thirds of the traded volume in the U.S. "High-frequency traders are the gorilla in the market," he said. In his view, the gorilla's footprint shrank in the days after the SEC's short-selling ban went into effect.

Unlike other market participants, registered market makers, including big high-frequency trading firms like GETCO and Citadel, were allowed to short financial stocks as long as it was done to hedge their market-making activities in those names. The SEC ban expired on Oct. 8.

But while the ban was in play, a host of hedge funds and proprietary trading shops that provided one- or two-sided liquidity to the markets found themselves sitting on the sidelines. Many firms with high-frequency trading strategies aren't registered market makers and aren't brokers. As a result, they couldn't short financial stocks. Statistical arbitrage strategies, whose continuous trading normally generates a lot of liquidity, had their hands tied by the ban. The convertible arbitrage market essentially evaporated for the duration of the ban.

Credit Suisse's Mathisson said some trading firms simply "shrugged their shoulders" and walked away from the market. "They [couldn't] just take out 840 names" from their black-box models so that they could play exclusively in non-financial stocks, where shorting was still allowed, he said.

Tal Cohen, a senior vice president at Instinet, agreed that the departure of many high-frequency trading firms from the market reduced the overall volume. The SEC's ban shut down many of those firms' strategies by preventing them from shorting financial stocks, he said.