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Spoofing, Surveillance and Supervision

Jay Biondo, Product Manager - Surveillance at Trading Technologies, co-authored an article along with James Lundy and Nicholas Wendland, both of Drinker Biddle & Reath LLP, reviewing the CFTC's regulations and expanding efforts, 21st century surveillance and supervision, as well as strategic recommendations.

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November 10, 2009

High-Frequency Traders Under Scrutiny

By Peter Chapman

Arzhang Kamarei, chief operating officer of Thesys Technologies, which provides start-up high-frequency shops with trading infrastructure, argues that spreads would only widen if the rebate system were banned. "Free-market principles would apply again," Kamarei said at a recent conference put on by Aite, an industry consultancy. "The market makers would not be making one-third of a cent or one-quarter of a cent from rebates--they'd make it from spread capture." Kamarei also said that today's rebate is significantly lower than the minimum trading increment that cushioned market makers before decimalization. Before decimalization went into effect in 2001, the minimum tick was 6.25 cents.

Adverse selection, or suffering the consequences of trading with someone with better information than you, has always been a problem for the market maker. Because of this, Getco's Nigito argues, market centers have to provide rebates in order to encourage dealers to provide liquidity. "When someone is on a maker-taker exchange," he said at an FIA/OIC options conference, "they are hanging themselves out to be hit by anybody."

An executive at one high-frequency trading firm argues that market making in its present form is superior to the way it used to be practiced. On the floor of the New York, for instance, specialists had an information advantage, as most of the orders collected at the specialists' posts, said Cameron Smith, general counsel at Quantlab Financial.

Today, "everyone is seeing everything at the same time," Smith told the Aite crowd. "No one really has a time and place advantage anymore. That makes it much more difficult to provide liquidity, but the markets are flat and fair for the most part."

By and large, the heaviest criticism directed at high-frequency traders stems not from their roles as market makers but the impact their trading has on large institutional orders. The critics are buyside traders and their agents.

"Their trading strategies will look to sniff out an institutional order and front-run it," Fred Federspiel, president of Pipeline Trading Systems, an agency broker that operates an off-board dark pool, said at the Traders Magazine conference. "If they see a repeated pattern in the market, they'll try to jump ahead of that and front-run it. That will lead to increased market impact costs for institutions."

The chief executive of one high-frequency trading shop that engages in predictive strategies acknowledges that "all high-frequency traders look for the footprints in the market," but argues that intense competition between high-frequency traders keeps prices close to their fair values. "The markets are efficient and self-correcting," Richard Gorelick, CEO of RGM Advisors, said at the Traders conference.

Gorelick added that institutional traders, through their brokers, have access to the same trading strategies as high-frequency traders. "They have co-located algorithms that use high-powered computers that take advantage of very smart mathematicians. All the techniques that high-frequency traders use are available to the buyside in trying to move large blocks."

Rishi Nangalia, an executive in Goldman Sachs' electronic trading department, seconded Gorelick. Nangalia noted that his group incorporates mechanisms into its trading algorithms that minimize the number of signals a large order can throw off.