The pros of high-frequency traders’ participation in the US equity market outweigh the cons, despite the negative press their influence has recently received, according to a new report from US agency broker Rosenblatt Securities.
Rosenblatt’s analysis, ‘An In-Depth Look at High-Frequency Trading’, acknowledges that the much-maligned practice – which it estimates accounts for between a half and two thirds of US equity volume –introduces cost and complexity to trading as well as benefits. However, it asserts, “We believe that high-frequency trading has a net positive effect on the quality of the market.”
One obvious cost, says the report, is the payment of rebates to liquidity providers through maker-taker pricing schemes, which are dominant in the US equity market. Electronic liquidity providers, the larger of the two broad categories of high-frequency trader – the other being statistical arbitrageurs – typically post passive buy and sell order in a stock on a venue in a bid to capture the spread, earning them maker rebates. Rosenblatt estimates that US exchanges and ECNs pay high-frequency firms $3.67 billion in rebates annually.
In addition, high-frequency traders’ superior technology allows them to post the best prices ahead of traditional brokers, earning them more rebates and leaving the slower firms to pick up the bill. Rosenblatt said two large Canadian banks told it that their active/passive ratios have increased by 5-10 percentage points in the past 12-18 months as high-frequency trading has taken hold in the country.
Equally, the buy-side institutions represented by the brokers may also have to pay the full spread more often than they would before the high-frequency dominance, said the report.
Rosenblatt also argued that although high-frequency traders often quote better prices than would be available without them, they can sometimes supplant ‘natural’ counterparties. This can lead to buy-side institutions missing out on a trade, and also can mean that consolidated volumes no longer reflect what institutions may regard as ‘natural’ buying and selling interest, potentially causing participation-based algorithms to overbuy or oversell.
However, the report added that while brokers and the institutions they represent may pay the spread more often as a result of high-frequency trading, the spreads are now far finer than they were before the high-speed phenomenon. Also, it argued that institutions routinely paid the full spread for Nasdaq-listed securities when the Nasdaq market was dealer-driven.
One clear benefit of high-frequency trading, according to Rosenblatt, is “massive” liquidity provision by making securities available to buy and sell at specific prices on an unprecedented scale. “This flood of limit orders upholds the spirit of Regulation NMS, which was designed to make price formation – and, by extension, capital raising – as fair and efficient as possible.” the report said.
Rosenblatt also contended that the intense competition high-frequency traders foster between exchanges, ECNs, dark pools and brokers for their order flow has resulted in innovation and lower fees for all.
Their most significant contribution, argued Rosenblatt, is their large role in reducing spreads, which has reduced transaction costs for all market participants, including the buy-side. Citing data from transaction cost analysis provider Elkins/McSherry, the report said institutional transaction costs had “plummeted” in the high-frequency era, which began in 1997 after the introduction of the Securities and Exchanges Commission’s order handling rules, Regulation ATS and the advent of ECNs.
“In short, high-frequency traders make markets more efficient,” said the report. “And that efficiency benefits everyone.”