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November 10, 2009

High-Frequency Traders Under Scrutiny

Opinions vary on rapid-fire traders

By Peter Chapman

Also in this article

In July, the New York Times ran an article implicating high-frequency traders in a range of misdeeds. In it, an industry leader complained the market was becoming two-tiered, with high-frequency traders having the upper hand. Then, in August, Sen. Ted Kaufman, D-Del., sent a letter to Securities and Exchange Commission chairman Mary Schapiro asking her to conduct a review of high-frequency trading, along with other market structure issues. He warned that with high-frequency trading comes the "potential for abuse." In September, the SEC announced it would investigate the practice, which now reportedly accounts for at least 60 percent of all shares traded.

Rob Hegarty, DTCC

All of a sudden, forces in the industry, on Capitol Hill and in the media have found a new bogeyman on Wall Street. High-frequency traders are being blamed for being too fast, for being fair-weather market makers and for ripping off large-block institutional traders. They're accused of being market parasites, shaving fractions of pennies off trades via high-speed computers to the disadvantage of almost everybody.

It's not the first time industry players or Washington or both have cried foul over a particular trading strategy and its practitioners. Last year, the villains were short sellers. In years past, they have been New York Stock Exchange specialists, Nasdaq market makers, SOES bandits and day traders.

Whether or not high-frequency traders (or any of the above parties) deserve the bad rap has become the focus of debate. At conference after conference (including one put on by this magazine) the pros and cons of high-frequency trading have been discussed. Given SEC interest in the issue, the talk is expected to continue into next year.

High-frequency traders generally fall into three camps. They make markets. They conduct arbitrage trades. And they make bets on the short-term direction of a security. In all cases, they are using their own capital to underpin their trades. They are proprietary trading shops without customers.

All three varieties rely on high-speed trading software and network technology to get in and out of positions. If they can't afford their own technology, they rent someone else's.

All turn over their portfolios frequently. All build their strategies around beating the next guy. Some are more latency sensitive than others.

It's a low-margin business, but because they trade so much, those fractions of pennies add up. High-frequency trading is not risk-free--hundreds of thousands of losing trades take place each day.

They may be small two-man shops dependent on others for trade processing, or they may be large organizations with their own infrastructures. They may be registered as broker-dealers. They may be investment advisers.


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One analyst believes there are between 300 and 400 high-frequency trading shops out there. More are expected. Some of them include firms like Jane Street Capital, Sun Trading, Renaissance Technologies, Two Sigma Investments and Hudson River Trading.