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Commentary: Do High-Frequency Traders Add Value to the Market?
Traders Magazine Online News, December 15, 2009
Heinrich Schliemann earned a place in the history books by discovering the ancient City of Troy in 1869. But before making this contribution to our cultural heritage, Schliemann was a trader.
Literally washed up on the shores of the Netherlands as an impoverished teenager, Schliemann ultimately found employment with B. H. Schoeder, an import/export firm. As it happens, Schliemann had an amazing ability to learn languages, and was ultimately fluent in 13 languages. Schoeder's clients usually could not speak the language of ship captains. So, Schliemann's job was to serve as a translator for clients purchasing goods from ships that docked in Amsterdam.
Schliemann quickly realized an important fact of life that remains true to this day. Translators, no matter how amazing their linguistic skills, receive a pittance for their work. Successful traders, by comparison, can make millions. So Schliemann pretended to translate the offers of ship captains, while actually purchasing the goods for Schoeder's principal account and then immediately reselling them for a profit to unwitting clients. Schliemann applied this technique with sufficient skill to avoid detection, making him a great success at Schoeder and personally very wealthy.
Of course, Schliemann was perpetrating a fraud on his clients. They were not hiring him to front run their purchases, but to act as a translator.
But, there is also a larger point. Schliemann wasn't adding any value to the transaction, other than serving as a translator of foreign languages. The free market's judgment was that he should receive a pittance for his work, like other translators, rather than a great fortune as a trader. Schliemann's profits were derived by skimming an advantage that rightfully belonged to his clients.
Institutional investors are in constant fear of being skimmed, which has spawned a growth industry in trading products designed to outwit the skimmers. Before things got so automated, institutional sales traders would cater to these fears by offering to find the "natural" other side. The theory was that if, for example, T. Rowe Price were to sell directly to Fidelity, they would receive a better price--all other things being equal--than if the sale were made to Merrill Lynch, a market maker. Naturally, a trading firm that could boast clients like T. Rowe Price and Fidelity could make this claim more credibly than a smaller firm that lacked such relationships.
Since the advent of Regulation NMS, dark pools have been all the rage. Pools that only have as members other big institutional investors are exclusive clubs where there can be more assurance that another big institution is taking the other side, rather than a modern-day Heinrich Schliemann.
The problem with this strategy is that institutions, not unlike lemmings, tend to move in the same direction. The reason for this is that securities analysts for institutional investors like to share notes, if not with each other directly, than indirectly through conversations with securities analysts at investment banks. Humans are social creatures, which means that we like to confirm our ideas with other like-minded people. The result is that everyone tends to be a buyer, or a seller, at the same time. The Europeans call this type of investment behavior "herding."
The consequence of herding is that when an institution seeks the "other side," it is more likely than not that a dark pool made up exclusively of other institutional investors will not produce one. It is at that point that a human trader earns his or her keep. A human will start calling institutions that have been interested in a security in the past to find someone who is interested. Institutions that have been generous with their commissions in the past are likely to get the first call. This gives them the opportunity to "price the merchandise."
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