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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February 18, 2010

Cover Story: Filling the Void

New firms alter the trading of illiquid ETFs

By James Ramage

Also in this article

By any measure, the world of exchange-traded funds has exploded. In the past two years, the number of funds trading on the nation's exchanges has surged 27 percent to 850. The mostly index-based funds now hold around $800 billion in assets, up from $622 billion just two years ago. All of that is good news for the trading community. In the same time period, the number of ETF shares traded has skyrocketed roughly 66 percent to more than 1.3 billion per day, outpacing volume in the broader market, which is up only 23 percent.

Brian Fagen, Barclays Capital

Propelling the surge, to a large extent, is the movement of long-only money managers into ETFs. Long a province of hedge funds, traditionals have gravitated to ETFs because the instruments are index-based and cheap to trade, and allow for easy exposure, diversification and hedging.

 

See Sidebar and Chart:

It's All Relative

Liquidity Spectrum

 

But while trading an ETF that tracks the S&P 500, like the Spiders (SPDR), is easy because the fund trades 160 million shares per day, there are a whole slew of them that require heavy lifting and force traders to earn their keep. Almost two-thirds of ETFs trade fewer than 100,000 shares a day, and 44 percent trade fewer than 25,000 shares a day. Those aren't the greatest liquidity characteristics to draw institutional interest.

 

The Agency Crowd

Here's the deal: As money managers started dipping their toes into smaller and more targeted funds, they noticed that the liquidity they needed for their exposures often dried up fast. In addition, they saw that capital, traditionally a natural remedy for illiquidity, wasn't nearly as abundant for less-traded instruments, industry sources said. And when it has been available, it's been expensive.

Over the past two years, though, ETF trading has evolved to fill the void. New and established players from the agency brokerage ranks have entered the ETF space to find novel and varied ways to trade less-liquid names more cheaply.

They've been using their relationships across the Street to find contra side flow, or building technology to draw it forth. To that end, they've been dedicating sales trading resources to work specifically with market makers and arbitrageurs that trade ETFs, as well as with the dealers--called authorized participants, or APs, who are also market makers--the large banks who create and redeem shares of them. They're finding counterparties who will tighten spreads and lower prices in thinly traded funds.

Firms that fall into this camp include new participants such as Fox River Execution and Street One Financial. They also include new desks, like ConvergEx's, as well as established ETF block traders, like JonesTrading.