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December 16, 2010

2010 Review: HFT Strategies Ignite Debate

By James Ramage

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  • 2010 Review: HFT Strategies Ignite Debate
  • Page 2

If the opponents of high-frequency traders are to be believed, then HFTs were responsible for the Great Chicago Fire. This is an exaggeration, of course, but not by much. HFTs spent much of 2010 under heavy shelling from regulators, brokers, institutions, politicians and the media. For the first half of the year, it was believed that HFTs accounted for between 50 to 70 percent of all equities volume. As such, their impact was seen to be significant, whatever the intentions of their practices. Subsequently, they've been heavily scrutinized.

But HFTs haven't sat passively and just taken the hits. They've actively banded together to answer their detractors. They've worked to counter the negative press and properly define their practices. They've written letters to the Securities and Exchange Commission, spoken on numerous industry panels and expressed themselves in numerous articles, opinion pieces and editorials seeking to answer every charge. They've tried to explain why their practices have been good for the markets by providing quality liquidity and tightening spreads.

What are HFTs? Defined loosely, they're firms that do 1,000 trades per second. They also comprise three primary types. Some make markets. Some do arbitrage trades. And some make bets on the short-term direction of stocks. They don't always trade solely in equities. And they also use their own capital for their trades.

In its Jan. 13 Concept Release, the SEC raised awareness of HFTs as order anticipators and requested comments on their effects on the marketplace. The SEC wanted to determine "whether the current market structure and the availability of sophisticated, high-speed trading tools enable proprietary firms to engage in order-anticipation strategies on a greater scale than in the past."

The Concept Release continued, judging order-anticipation strategies to be dangerous to long-term investors when they seek liquidity to enter into or liquidate a position.

Next, some industry studies purported to show how HFTs have harmed the markets through anticipatory trading. One, by Quantitative Services Group, a transaction-cost research provider, attempted to show how HFT firms with strategies designed for short-term gains use pattern-recognition software to determine the direction of prices and find signals generated by large orders. The study tried to give numbers to the fears about HFTs that large institutional traders were developing: that some HFTs sniff out their orders in the marketplace and run ahead of them for profit.

Concerns about anticipatory trading stretched all the way to Capitol Hill. In March, Sen. Ted Kaufman, D-Del., addressed the Senate at length about how HFTs were negatively affecting the equities markets. Among his many complaints, he mentioned how these firms that beat institutions to the punch and trade ahead of them are more than just the latest iteration of an old strategy.

"While traders have long tried to trade ahead of large institutional orders, they now have the technology and models to make an exact science out of it," he said.

The SEC, feeling the pressure from Congress, responded with its Large Trader proposal. It would require brokerages to code the tickets of their most active traders, so that their trading patterns could be tracked by the SEC. This rule would help the SEC understand HFTs better at a time when there was little actual data covering their activities.