Friday, September 28, 2012

High-Frequency Trading: What's Next?

Let's pause for a moment, if the lightning pace of high-frequency trading permits us to do so. In the U.S. today, high-frequency, electronic, computer-aided trading accounts for as much as 65 percent of all stock-volume activity.

Computers whiz and hum.  Black boxes send out trading orders in thousands and millions of shares, and rout orders to exchanges and "dark pools" all over the globe. Execution occurs in fractions of a second. Algorithms and programs determine what to buy, when to buy, when to sell, when to buy and sell at the same time and on which one of a dozen or more electronic exchanges. Algorithms provide guidance on volume, prices to show, prices to execute, and prices, if only for a few seconds, to report as "bids" or "offers."

High-frequency traders dart in and out of trading positions in seconds. Some firms buy in one venue and sell in another. They earn pennies per share, but generate large profits via big volume--tens of thousands of shares bought and sold in seconds. Tens of millions of shares throughout the day. Many buy or sell shares in one venue and simultaneously sell or buy the related derivative over the counter, in another country, or in exchange thousands of miles away. Execution and profit-generation are confirmed by the flickering of light on computer screens. 

Traders--or actually, their humming black boxes--study patterns, trends and data. They look for discrepancies, distortions, or something out of line. Traders (yes, humans, often quantitative analysts and experts) update computer code and write more algorithms to instruct their firms to deploy more capital to get into and out of trading positions in seconds. Timing is of the essence. 

Many aim to finish the trading day with neutral positions--little or no overnight risk. Some preside over non-stop trading--trading into and out of positions, making markets, and providing bids and offers all over the globe for a continuous 24 hours.

Some trade other "asset classes," as well, exploring similar opportunities in instruments beyond equities, looking to do the same or find discrepancies and trends in foreign currencies, options, convertible bonds, and government bonds. Or they seek to decipher relationships between "asset classes" (convertibles and equities, bonds and mortgages, options and equities, interest-rate derivatives and bonds). Most trade for their own accounts; many trade or execute for customers and clients.

Over the past several years, they have  include such firms with unfamiliar names as Getco, Jump, Allston, Gelber, Jane Street, Sun and Quantlab. They also include hedge funds and clients of hedge funds and asset managers. Occasionally they may include other types of funds (investment funds, pensions and endowments), all looking for an advantage based on rapid execution and "best prices."

In the realm of finance, some say this is exponential progress. Compare to the more docile manner of trading in the early 1970s, when stock certificates were exchanged, counted, bundled, boxed and rolled into the vaults of brokerage houses all over Wall Street from day to day, creating such a paper-work crisis that the industry once days off to recover from the mounds of paper.

Others say this represents a setback for retail investors or value-oriented investors. Is anybody among the throngs of high-frequency traders buying stock to support a company's investment in a new business, investment in sales growth, or investment in expansion to a new region of the country?  Do they care for more than a few seconds about a company's new-product strategy or its business plans for 2013?

Many high-frequency firms rebut that they contribute to capital markets in several major ways:

(a) They provide market liquidity, active markets, and ready buyers and sellers.

(b) They provide "price discovery" with bids and offers updated continuously during the trading day.

(c) They provide "best prices," opportunities for buyers and sellers to search venues to find the best price for a particular stock.

Their detractors argue they hamper markets in many ways:

(a) Unlike the stock specialists in the past, they disappear when markets become too volatile. They balk or refuse to participate at certain times.

(b) They don't always provide honest, good-faith bids and offers. Sometimes they show their hands and wander away before execution.

(c) Skipping from venue to venue (electronic exchange to electronic exchange) with less-than-sincere bids and offers, they often try to trick or deceive markets to gain information advantages--advantages that slice profits from retail- and long-term investors.

And they cause what happened in May, 2010:  the "Flash Crash," when the market fell (Dow Jones) almost 1,000 points (9 percent)--a precipitous, unfathomable, and bizarre collapse in minutes for no explained reason. Perhaps just as odd was the market's subsequent rebound the same day.

It took months for market experts, regulators, and exchange officials to figure out what happened. Some still don't agree. Most worry that flash crashes, in this new, 21st-century trading environment, will appear regularly. Many are concerned about the impact of a market (or markets covering all asset classes and many geographies) on individual investors. What are the virtues and attractions of a marketplace where the better capitalized electronic traders appear to have an ongoing advantage, where these traders get access to the best prices and best execution, and where 1,000-point, unexplained drops in the Dow are regarded as by-products of the game?

Over the past year, we've seen other debacles and unexpected turmoil in equity markets.  BATS, an electronic exchange, widely known for its swiftness in execution and the technology that supports it, botched and then canceled its own IPO offering earlier this year--because of technology glitches.  This summer, Knight Trading, a market-making firm, botched an electronic-trading vehicle that was intended to allow even retail investors to have better electronic access at the New York Stock Exchange. That led to losses over $400 million and several days of its existence in jeopardy.

What will happen next? And to whom? Will there be another collapse of some kind, something unpredicted, unexpected out of nowhere--blamed on high-frequency traders, but inexplicable or puzzling to the public at large?

Where do we go from here? Do we allow the marketplace by itself to resolve these quirks, collapses, and unpredictable swirls? Or should regulators (from Congress to the SEC and CFTC) rush in to take steps, even as they try to understand trading models that are racing a hundred steps ahead of them. 

Attempting to understand their trading schemes (their intents, purposes and profits) can be a mind-boggling exercise for those who contemplate regulation. What are their strategies?  How do the translate strategies into profits? How do they allocate capital? While the black boxes hum away, how do senior managers stay on top of the activity? Perhaps most important, how do they approach and manage risks--risks to their firms and risks to counter-parties and other traders and investors in the market?

No one knows for sure what the right next steps should be--at least in the U.S. Should there be transaction fees or taxes to restrict such activity? Should there be increased capital requirements for participants--as protection against what would likely be yet the next big loss or flash crash?  Should regulatory review boards approve all trading strategies and trading innovation?

Many of the same trading firms preside over or direct trading into what are called "dark pools"--private in-house marketplaces where electronic firms can exchange thousands of shares without having to let public markets see what they are doing. In some ways in the industry, it appears what could happen next--near month or next year--is like wandering into an unknown, uncertain "dark pool.

We're likely at a precipice.

Technology innovation will continue, as long as there are profit opportunities. Some argue profit margins will decline as the number of participants increase, and that in itself could slow down the rush to be the fastest in executing trades on the planet.  With other priorities on their plates (Dodd-Frank and Basel 3, most notably), regulators won't be able to catch up quickly, always hustling from several steps behind, panting while trying to project what is the worst that could possibly happen.

Meanwhile, feeling disadvantaged and sometimes clueless, worn down by the equity-market tumult from the crisis, retail investors seem to have decided to watch this play out while they remain on the sidelines.

Tracy Williams

See also:

CFN:  Dark Days at Knight Capital, 2012
CFN:  Market Volatility, Can You Stand It? 2011
CFN:  Uncertainty in Markets, 2011
CFN:  Here They Come, the Volcker Rules, 2011

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