If anyone in the industry was oblivious to the role of high-frequency traders before 2009, they certainly aren’t now.
The group got caught in the glare of the spotlight this summer, after politicians and the national media sounded the alarm that these largely unknown traders might be up to no good. They had special privileges that allowed them to profit at the expense of the regular Joes in the market, it was suggested.
A missive from Sen. Ted Kaufman, D-Del., to Securities and Exchange Commission Chairman Mary Schapiro, asking her to conduct a review of high-frequency trading, among other trading issues, hit home. The SEC is now in the process of gathering information about the practice. Its fact-finding could lead to possibly regulating the practitioners, or changing some rules.
In fact, the SEC has already taken steps to regulate a crucial aspect of the high-frequency trading game, that of co-location. As Traders Magazine reported in October, the SEC will regulate Nasdaq’s service of offering rack space for traders’ servers located near its matching engine. Placing one’s trading server in close proximity to a market center’s matching engine confers speed advantages on the trader.
The glare of the spotlight may not have been such a bad thing. Over the course of the summer, the industry learned a great deal about these trading shops, which take their profits in fractions of a cent per share, moving in and out of positions at sub-millisecond speeds.
There are an estimated 300 to 400 high-frequency trading firms. They may or may not be broker-dealers. Their names include Jane Street Capital, Getco, Sun Trading, Renaissance Technologies, Two Sigma Investments and Hudson River Trading.
They are highly coveted customers of brokers and exchanges alike because they trade so much. Analysts estimate their trading accounts for between 60 percent and 70 percent of total industry volume on any given day.
That is, of course, a lot. It makes them vital to the health of the market, many say. "I’ve spoken with a lot of buyside shops ever since joining DTCC," Rob Hegarty, a managing director in charge of market structure at the Depository Trust & Clearing Corp., said at a recent Traders Magazine conference. "Virtually every one said that if it weren’t for the high-frequency traders, they would have no liquidity."
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.
They may be small two-man shops dependent on others for trade processing, or they may be large organizations with their own infrastructures.
By and large, the heaviest criticism directed at high-frequency traders stems not from their roles as market makers but from 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. "So you shouldn’t worry that these trading strategies are disadvantaging institutional investors."
Gorelick added that institutional traders, through their brokers, have access to the same trading strategies as high-frequency traders.
Peter Driscoll, head of trading at Northern Trust and an official of the Security Traders Association, testifying at a Senate hearing in October that covered high-frequency trading, among other topics, noted that high-frequency traders go with the territory.
He told the legislators: "It’s my job to stop the people trying to take advantage of my orders. When I have an order working and I see it starting to move because high-frequency traders have sniffed it out, I’ll remove that order from the marketplace and wait until the price reverts to where I want to buy or sell the stock. It’s part of the job of the institutional trader to trade against these people."
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