When the British Broadcasting Corporation (BBC) makes a radio documentary about high-frequency trading, you know you’ve got a phenomenon on your hands. Hard on the heels of hedge funds managers, private equity partners and investment bankers, a new financial bogeyman has now been forced out of the shadows; the high-frequency trader.
Like hedge funds before them, the political concern about high-frequency traders stems in part from a perception that they enjoy an influence over the financial markets out of proportion with their public profile. To put it another way, just who are these guys?
High-frequency statistical arbitrage trading by small proprietary trading firms has been around for many years, not only in equities, but also in the foreign exchange and derivatives markets. Making money out of pricing inefficiencies and mean reversion has a long if not necessarily distinguished history in the financial markets. The activity has grown in line with the proliferation of trading venues that can facilitate the arbitraging out of tiny pricing differentials, with greater firepower required by the stat arb firms to exploit ever smaller inefficiencies.
But the key reason why high-frequency trading now accounts for 60-70% US equity trading – and a growing proportion of cash equity volumes in London – is the growth of automated market making. Traditionally, a high-risk and capital-intensive business carried out by specialist arms of broking firms and investment banks, market making has changed in a number of important ways. Although today’s automated market makers still offer two-sided markets, making money on the spread between their buy and sell prices, they no longer carry risk overnight, or even over lunch. Intensive use of immediate-or-cancel orders allow automated market makers to enter and exit multiple positions over extremely short periods, even microseconds. With automated market makers sending, then cancelling, many thousands of orders per second, it is little wonder that the pricing strategies (and technology budgets) of trading venues old and new have been skewed to attract high-frequency trading.
The speed with which they trade and the volume of market data they consume has made the growth of high-frequency trading a concern not just for politicians and media outlets, but also for the trading desks of traditional buy-side institutions. Does the information and technology advantage held by high-frequency firms mean that their flow should be avoided by long-only asset managers? The ability of automated market makers to use price information from a buy-side desk’s sell order, for example, to turn a quick profit by providing instant liquidity, then offloading the position in an instant, places some institutional investors in a quandary. They welcome the provision of liquidity at attractive price points, but are they pawns in the high-frequency trader’s game if the latter is immediately able to find a better price through superior technology and connectivity? John Serocold, director, London Investment Banking Association, told the BBC that there is little difference between the business model of an automated market maker and the ability of a second-hand-car salesman to sell your car for more than he paid you for it. But is ‘caveat emptor’ enough?
Some regulators and politicians think not. Not only are they concerned about the lack of a level playing field for all equity market investors, but also the wider implications of the high-frequency gold rush. If all the financial markets’ investment and focus is spent maximising liquidity in blue-chip stocks, what then of the mid-cap firms that have traditionally come to the equity markets to raise funds for growth? The wider picture also includes the ongoing regulatory and popular backlash against the financial sector. With calls growing louder for a ‘Tobin’ tax on all financial transactions, it seems unlikely that the high-frequency arena will escape regulation for long.
To vote in the new poll on high-frequency trading, please click here.