Man Vs. Machine: Pros and Cons of High-Speed Trading
Floor Broker of the Digital Age
It can get even more complicated than that, of course. The HFT may employ strategies that believe it can successfully move the offer higher if it believes the buyer is large enough. The HFT may also decide to short the stock to the mutual fund, under the assumption that once a large buyer is done in IBM, the price historically moves down.
Is This Illegal?
The SEC has indicated that as long as the practice does not violate a fiduciary duty to a customer or involve misappropriating information (creating rumors) there may not be a violation, but they clearly are suspicious of this activity and have asked for comments on whether they harm institutional investors.
The second concern is momentum ignition strategies, which involve the rapid submission and cancellation of many orders combined with a small number of actual trades. What does this do? The hope is that other algorithms will notice this trade, and will cause them to buy or sell more aggressively than they might have. The HFT will sell as the stock is going up, and buy as it is going down.
It's pretty clear that the SEC takes a dim view of this kind of activity as well. They noted that "any market participant that manipulates the market has engaged in misconduct that already is prohibited. "
Do mutual funds or pension funds realize they might be getting gamed, even if it's only a penny? They may, or may not. They may have sophisticated programs of their own to fool the pattern recognition systems. Others may have other criteria beside price, such as trading with a particular broker-dealer in exchange for research, or IPO allocation, or getting invited to seminars.
"You can trade at 10 different exchanges and 30+ alternative trading systems. So we have a number of different ways of trading a stock and it really depends on the size of the trade, the liquidity of the stock," says Vanguard's Gus Sauter.
What percentage of HFTs use order anticipation and momentum ignition strategies? It's likely a very small percentage, but we don't really know. And that is a problem. Another complaint:
- Co-Location and Other Practices Are Forms of Legal Front-Running
Most of these accusations are groundless, but there may be some instances of abuse.
Because HFTs rely on super-fast (millisecond) trading, they have sought to put their servers as close as possible to the servers of the exchanges to cut down on the time it takes to send and receive information. "Maximum speed to the exchanges is desirable, so we put our servers physically at the exchanges," says Tradeworx CEO Manoj Narang.
This practice, known as co-location, is very profitable for exchanges—they charge for the privilege. Indeed, the New York Stock Exchange has just completed a large new data facility in New Jersey, partly to collect fees from HFTs and other traders who need fast access.
Of course, co-location are just the latest tricks for traders to have quick access to trading. In the old days, floor traders at the NYSE were paid to stand around all day and react quickly to market events, which gave them an advantage over someone calling in a trade.
Co-location is the digital age's response to the floor broker. Still, there is a legitimate public policy issue. If the public believes that this gives hedge funds and HFTs unequal access to exchanges, that is a concern.
There have been allegations of more serious abuse. One organization that studies trading patterns, Nanex, has alleged that one or more HFTs have deliberately been "stuffing" the tape with bids and offers that are rapidly cancelled, all in an effort to slow down the system by a few milliseconds—or more. Why? HFTs may be able to take advantage of that time lag.
Other have complained about direct market access, also known as "naked access," which allows HFTs to use a broker's computer code to access markets.
Why is this important? HFTs use brokers to access exchanges, but brokers must risk-check the HFT—they must, for example, make sure they are authorized to make the trades, a process that takes a fraction of a second. Naked access allows the HFT to use the broker's "membership card" to get to the exchange a fraction of a second earlier.
The downside: it's not clear who exactly is making the trades, because the HFT is using the brokers "pass" to access the markets, and checks to make sure that trades are meeting parameters set by the exchanges are not being made.
What can be done about these perceptions? Again, the public must believe that HFT techniques pass a basic "smell test" of fairness:
- Make sure that technologies are equally accessible. The SEC is not going to ban high frequency trading, but certain practices—co-location and naked access—are rightfully under scrutiny. The SEC has already floated a proposal to ban naked access, but it has run into industry opposition.
The SEC has already stated that co-location facilities cannot be unfairly discriminatory, and the fees must be reasonable. But there is still considerable discussion about whether long-term investors, who may not be able to use or afford co-location facilities, are being harmed by this practice.
- Consider bringing high frequency traders and other proprietary traders into a tighter regulatory framework. It is difficult account for 60 to 70 percent of the volume (as high frequency traders have become)—and take the place of traditional specialists and market makers—and not be subject to any regulations at all.
For example, HFTs (those over a certain volume threshold) should be required to register with the SEC and be subject to risk compliance checks.
The SEC has proposed a Large Trader Reporting System that would enhance its ability to identify market participants.