Risk Magazines recent revelation that the dominant liquidity providers in the United States Treasury market are high frequency traders shows that treasuries are quickly transitioning away from a dealer-driven, cherry-picker market to an all-comers market. That is a market where all participants have to be willing to essentially take on anyone, anytime, anywhere much like a champion boxer willing to take on all-comers. Clearly, this creates a fairer more competitive market that drives down trading costs for all investors. Yet, some critics claim that our treasury markets, like our equity markets, are in need of immediate reform. They point to characteristics such as constant quote changes, and smaller transaction sizes to support their case.
But what if these very features are actually the logical and desirable consequence of a truly fair and competitive all-comers market?
The core operating principals of an all-comers market, such as an equity exchange like Nasdaq or a treasury market such as BrokerTec, are anonymity and non-discrimination. Active traders on these markets can potentially trade with participants ranging from retail investors to institutions with large market moving orders to low-latency HFT firms. Therefore, all-comers markets are generally going to be dominated by market participants that have the skill and sophistication to trade with anyone. Given that one never knows when they could end up interacting with the trading equivalent of Mike Tyson, it is intuitively obvious why the successful liquidity providers must update their quotes frequently and reduce their average trade sizes while simultaneously submitting competitive quotes that narrow the spread.
In contrast, quotes in dealer markets inside large investment banks are displayed exclusively to a carefully curated set of customers that are generally unsophisticated and are unlikely to cause a dealer to experience pain in the form of trading losses. Further reducing the risk of loss is that the dealer does not need to be very aggressive with his quote since he always gets the opportunity to trade with his customers regardless of his quoted price. Further, the dealer can even back away from a quote through the practice of last look. The strategies used by dealers in this favorable environment, however, do not translate well to an all-comers market.
Early in my career I experienced, a great example of a dealer having trouble adjusting to an all-comers market. At the time, Madoff was one of the largest, most respected market makers for retail orders and consistently had the highest execution quality in the industry. But that distinction was deceptive. Madoff was able to provide high quality executions solely because, as pioneers of executing retail orders, Madoff was able to trade with relatively un-sophisticated investors like the dentist that places orders between the 9s on the golf course based on a tip from last nights party. This client base made it easy for Madoff to guarantee relatively large sizes at great prices. But when the brokerage firm Datek On-line and its client base of sophisticated day trading clients began sending orders to Madoff, Datek was asked to stop sending their orders after just one day! The Datek episode revealed that the vaunted Madoff execution quality was an illusion akin to the fighter that takes on poor opponents to build a 30-0 record but goes down in the first round against a quality opponent.
Similarly, in the Treasury market, dealers historically have streamed private quotes to a client base consisting of corporate treasurers, municipalities and other rough equivalents of Madoffs dentists. That private market model is now changing for many reasons including multiple successful lawsuits by regulators against dealers for price fixing and collusion together with the growing savvy of the dealers customer base. With order flow migrating to all-comers marketplaces like eSpeed and BrokerTec, nobody should be surprised at the revelation that HFTs are eight of the top 10 liquidity providers on these markets given their required attributes for success. Effectively, HFT shops are like Bruce Lee fighting 20 ninjas simultaneously while dealers, until recently, were fighting one novice at a time.
While many may logically acknowledge that all-comers markets would favor certain skills, some are still shocked and concerned at HFTs dominance. Much of the concern is caused by the term HFT that causes observers to believe something new is occurring. The fact is that all professional traders utilize low-latency, algorithmic trading strategies. Period. The only difference between a bank and an HFT is that HFTs are simply small independent firms rather than a trading team tucked into a division within a large investment bank. The likely explanation for why independent HFTs have outcompeted bank HFTs is that the independents were better able to create the nimble, entrepreneurial culture that best supports the process of creating strategies that can consistently succeed on brutally competitive all-comers markets.
So the next time some alleged expert appears in the media complaining about fleeting liquidity and small trade sizes, consider why this change has occurred and what characteristics we would expect to see in a truly competitive market. Only unfair and discriminatory markets have the characteristics of large size and slow moving quotes (e.g. the currency exchange rate at the hotel concierge desk). If we want truly transparent, competitive markets where the person with the best price gets every trade rather than the person with the best sales force, then we must learn to embrace these characteristics of modern electronic markets where every participant must be willing to take on all-comers.
Cameron Smith
President, Quantlab Financial, LLC
A Houston based developer of quantitative trading strategies
