Some market volume may be missing in action. The Securities and Exchange Commission’s temporary ban on short sales in financial stocks appears to have chased liquidity out of the market, according to several broker-dealers.
Last week’s volume was high by historical standards, but some think it was suppressed by the ban on short-selling that went into effect 10 days ago, on Friday, September 19. “The high-frequency players are turned off right now because of the SEC ban on short-selling in financial stocks,” said Dan Mathisson, head of Advanced Execution Services at Credit Suisse. “On days like these, with so much news on the tape, I’d have thought we’d see 13 billion or 14 billion shares.” Mathisson and the others quoted in this story spoke at a Traders Magazine conference last Wednesday.
Consolidated equity volume hit all-time daily records in the two days running up to the ban, reaching 18.7 billion shares on September 18. Volume was just under 16 billion on the 19th, when the ban was implemented. Volume fell to 8.8 billion shares last Monday and Tuesday and 8 billion on Wednesday. It skipped up to 9.4 billion shares on Thursday and dropped back to 8.8 billion on Friday. Average daily volume in the first half of the year was under 8 billion shares, compared to 5.8 billion shares in the year-earlier period.
Joe Gawronski, president and chief operating officer at Rosenblatt Securities, estimates that high-frequency trading in recent months has represented half to two-thirds of the traded volume in the U.S. “High-frequency traders are the gorilla in the market,” he said. However, he added, the gorilla’s footprint shrank in the days after the SEC’s short-selling ban went into effect.
Unlike other market participants, registered market makers, including big high-frequency trading firms like GETCO and Citadel, are allowed to short financial stocks as long as it’s done to hedge their market-making activities in those names. The SEC ban currently expires on October 2, although it is expected to be extended past that date.
However, the ban sidelined a host of hedge funds and proprietary trading shops that provided one- or two-sided liquidity to the markets. Many firms with high-frequency trading strategies aren’t registered as market makers and aren’t brokers. As a result, they can’t short financial stocks. Statistical arbitrage strategies, whose continuous trading also generates a lot of liquidity, are in the same boat. Credit Suisse’s Mathisson said some trading firms simply “shrugged their shoulders” and walked away from the market. “They can’t just take out 840 names” from their black-box models so they can play exclusively in non-financial stocks, where shorting is still allowed, he said.
Tal Cohen, a senior vice president at Instinet, agreed that the departure of many high-frequency trading firms from the market last week has reduced volumes. He said the SEC’s ban shut down those firms’ strategies by preventing them from shorting financial stocks.
“I’m not sure they’re 50 to 60 percent of the market, but they’ve been a disproportionate share of the increase in volume” in recent years, he said. In 2003 and 2004 the market was executing three billion to four billion shares per day, Cohen said, whereas now it’s in the seven-to-10-billion range. He added that the rise of trading by these firms is the result of reduced friction in the markets and regulation that has enabled the high-frequency firms to operate efficiently.
Bill O’Brien, CEO of Direct Edge ECN, said he wouldn’t be surprised if high-frequency trading firms represented 45 percent or 55 percent of the market in recent months. These firms, he said, are appealing customers to most market centers because they can boost a venue’s market share. “They can synthesize new flow,” O’Brien explained. “For the high-frequency firms, order flow is not customer-based.” In his view, their current time-out from the market will affect industry volume as long as the ban continues. And that could impair liquidity.
While there’s general agreement about the influence these firms exert on market volume, there’s less certainty about the value of that liquidity for institutional orders. For Instinet’s Cohen, the disappearance of that liquidity from the market, even temporarily, negatively impacts firms on the buyside. “It’s like an ecosystem: If you take some players out, other people will act irrationally,” he said. “If liquidity providers are not there, that’s ominous.”
Mark Enriquez, chairman of broker Pulse Trading, doesn’t agree. The liquidity provided by high-frequency traders “is low-quality liquidity” that’s not good for the institutional market, he said. In his view, institutions are hurt by players making “micro markets” lasting less than a second or for a couple seconds, because those players have made capturing liquidity without moving the market harder. Models at those trading shops, Enriquez said, sniff out buyside interest and change their markets and trading strategies to take advantage of that knowledge.
Direct Edge’s O’Brien pointed out that with the ban in operation, micro markets will become more docile. He speculated that “micro volatility,” or spikes of volatility that last for no more than a couple seconds, might decrease, although one-day volatility could increase without the liquidity provided by these firms.
Other brokers observe that the liquidity generated by high-frequency trading strategies is a different kind of liquidity than was provided by erstwhile market makers, and that this new breed of liquidity providers has altered the trading dynamic. The key difference is that these firms trade only when they want to trade. According to Rosenblatt’s Gawronski, high-frequency trading firms don’t have the types of obligations to the market that specialists once had. “Traders complained about Nasdaq market makers or the NYSE specialists, but they actually took positions,” Gawronski said. “The high-frequency guys must be paid [to provide liquidity]. “It’s about temporary liquidity provision. They unwind their positions in milliseconds.”
Still, while the Rosenblatt executive said some of these firms were sitting out the action at the moment, he wasn’t prepared to pass judgment. “I don’t know if high-frequency trading is good or bad,” Gawronski said. “But I know transaction costs are coming down and more volume is trading. It’s just different now.”
