differences between wholesale and retail market participants mean institutional
investors must take action to avoid being disadvantaged by high-frequency
trading (HFT), says Seth Merrin, CEO and founder of block trading venue Liquidnet.
“Sometimes regulations aimed at curbing HFT activity
can be effective, but I don't think this is the preferred route,” said Merrin.
“Institutions need to take steps to protect their clients’ order information.”
There has been a
renewed focus on HFT that has coincided with the second anniversary of the
flash crash – an event on 6 May 2010 that saw the Dow Jones Industrial Average
plummet by almost 1,000 points in the space of around 20 minutes before
rebounding just as quickly.
While HFT was not
the direct cause of the flash crash – an investigation by US regulator the
Securities and Exchange Commission pinned the blame on a botched algo trade
from a mutual fund – it raised questions relating to the safety of today’s
market structure, of which HFT is a big part.
estimates put the proportion of HFT at 40% in Europe and up to 60% in the US.
technology glitches common in a trading environment that is now dominated by
computer-driven trading, Merrin says such events shouldn’t be accepted as a
cost of business.
crash, the SEC implemented single-stock circuit breakers, banned firms from
accessing markets without pre-trade risk checks and introduced reporting
requirements for traders are firms deemed ‘large traders’.
thinks the new rules have not done enough to reinstate market confidence.
“Clearly confidence has not come back into the
market,” said Merrin. “New rules such as the circuit breakers were more of a
band aid to keep irrational pricing within bounds, but we haven’t done anything
to stop the catalyst for something like the flash crash from reoccurring.”
When it comes to
HFT, Merrin argues that the prevalence of this activity can cause a fundamental
disconnect between the underlying fundamentals of a company and its stock
price. The fact that a growing proportion of trading activity is “completely
valuation agnostic” poses a real risk of market failure he says.
“When the majority of trading volume disregards the
connection between price and a company’s fundamentals, it risks leading to
irrational pricing, which ultimately can result in a flash crash-type event,”
Merrin says. “While there are some HFT strategies, like statistical arbitrage
and pairs trading, that help keep prices in line, many others play off
supply-demand imbalances, which only exacerbates market volatility and comes at
the expense of the institutional investors and all the people who invest with
Rather than look
to new regulatory initiatives, such as the financial transaction tax, labelled
by Merrin as a “terrible idea”, there needs to be more focus on solving the
underlying problem – better protection of wholesale investors interests. Merrin
advocates a dual market structure that separates wholesale investors from HFT firms
and professional retail traders.
attempts to do this via its trading venue that seeks matches for large blocks
of stock on buy-side traders’ blotters. When the venue finds a match, buy-side
traders then enter into a private negotiation in order to complete the
execution. The firm also effectively serves as the block trading market of SIX
Swiss Exchange through its SIS Swiss Liquidnet Service, and is looking to
establish similar partnerships with other bourses.
“You cannot have one single venue that adequately
meets all investor types’ needs,” he says. “When you want to trade 100 shares
of a stock you need very different tools than if you are trading a million
shares of stock. Creating a wholesale market where size meets size, next to the
retail market takes away the supply-demand imbalance and eliminates the
catalysts for HFT strategies. It is incumbent on the buy-side to safeguard
their client’s information and protect their orders.”