Man Vs. Machine: Stock Exchanges Embrace ECNs

Trading volume on ECNs has exploded

Supporters say ECNS help liquidity

Critics say plaforms have unfair advantage

NYSE Traders
Oliver Quilla for
NYSE Traders

It has all the making of a family drama—a generational divide, co-dependency and big money—except we are talking stock trading, not TV.

It's a battle born of a two-decade-long push by institutional investors to speed trades and lower costs. The new technologies and regulations behind those efforts have given rise to the investing world's newest generation: high-frequency traders.

To critics, their unfettered growth is a blessing and a curse. A blessing because they fill holes made by the changes they pushed for, a curse because the new generation does not play by the old set of rules. The result to some is uncertainty about the markets that is keeping the family's elders, retail investors, out of the market.

It's a problem regulators are trying to remedy.

"We need to constantly make sure that our market gives people the confidence to invest," said Larry Leibowitz, COO of NYSE Euronext.

That confidence was shaken by the Flash Crash of May 6, 2010. The sudden 600 point decline in the Dow Jones Industrial Average raised questions about the market's stability. It also put high-frequency traders in the spotlight. The increased scrutiny is largely due to concerns about the stability of the liquidity they provide, and criticisms they inhibit, rather than help, price discovery in the market.

Securities & Exchange Commission Chairwoman Mary Schapiro touched on this during a speech to the Economic Club of New York. "I believe the rules that govern our equity market structure more broadly need to keep up with the changes in the market," she said.

Among the changes in the market over the last fifteen years, the growth of ECNs, what are basically electronic venues to buy and sell stock. They were introduced to cut trading costs.

Add to that decimalization, or the narrowing of the spread to a penny, of the bid and ask price of a share of stock. Mix in new technology to speed the trades and you have a new breed of trader that makes money not buying or selling stock based on metrics like book value and PE ratios but computer programs written to detect, and exploit, changes in price patterns in stocks.

The trader makes money buying amounts of stock then selling them quickly. The price differential may be in the pennies but the profits can add up to the millions if enough shares are traded. This is what high-frequency traders do, both independent companies and desks run by big institutions like banks. And while they are being criticized now, points out their presence is beneficial to the markets and other investors.

"Our volume is higher than its ever been." he said. "Commissions that hedge funds, and mutual funds and investors pay are far lower than they've ever been," said Leibowitz, who added he believes the issue isn't really high-frequency traders but a market structure in need of a new rule book.

"We've had market makers on this planet for 400 years," he said. "They have always traded according to patterns in the stock and liquidity in the stock. There's actually no conflict here at all. It's always existed this way. We just need to make sure that the rules are there and more transparent."

Leibowitz says he's not an apologist for high-frequency traders. He sees them as part of the natural evolution of technology that makes some people uncomfortable. The New York Stock Exchange, he notes, has had to adjust too. The changes in market structure and growth of high-frequency trading have contributed to the steep decline in its share of trading volume—from more than 80 percent of all listed trades to about a quarter of them.

The number of market makers on the NYSE floor has dwindled to the single digits. The narrowing of spreads has made it difficult for them to make a profit. As a result, many were sold to banks like Goldman Sachs , or closed shop. In their wake high frequency-traders have filled the void, providing liquidity to the markets. In return, they are given rebates by the exchanges.

"We actually pay them to provide liquidity because what helps create market quality is more liquidity, tighter spreads," said Leibowitz. "Its good for market quality, that's good for speed of execution, that's good for volume."

Stacked deck?

Invescodirector of global equity trading, Kevin Cronin, acknowledges the benefits brought by high-frequency traders but feels they also have certain advantages unavailable to other investors.


"It should be asked to those whose advantage is conferred, that we ask if there be some corresponding obligation," he said.

Among those advantages, they do not have to act like traditional market makers. If the markets head in a direction that does not correlate with their computer driven strategies, high-frequency traders can step away from the market. There is nothing illegal about this, but by stepping away, the pools of stock they trade evaporate. Given they account for more than half of the trading volume on the exchanges today their absence makes it hard for other investors looking to buy and sell stocks to do so at a fair price.

"Quote depth, requiring two-sided markets in good times and bad, a combination of size requirements and other depth requirements," said Cronin, ticking off some of the things high- frequency traders should be obligated to provide. Requiring them do some trading during periods of upheaval might assist in orderly trading, rather than sudden swings, like with the Flash Crash.

Cronin says the traders have another advantage—location. Along with other institutional traders they rent space for their servers in data centers operated by the NYSE and Nasdaq OMX . In an era where speed counts, so does location. The closer you are to the exchanges servers, the faster your trades are executed and the quicker you see quotes. Given retail investors cannot afford this advantage, Cronin argues it creates an unlevel playing field.

"It would not surprise me if colocation services became a 50-percent plus margin business as more and more customers enter these data centers."" -Invesco, Kevin Cronin

But Leibowitz points out retail investors do benefit from this co-location if their broker houses their servers at the data center too. He also points out since the markets began, proximity has always been a key element for any investor. Traders closest to the buttonwood tree in lower Manhattan, where the NYSE got its start in 1792, were likely to have their trades executed more quickly than those stationed farther away.

Still, its does raise the question as to whether public exchanges like the NYSE and Nasdaq are conflicted. Both serve two customers, their shareholders, and investors to whom they have a duty to maintain a transparent, competitive marketplace.

BMO Capital markets analyst Mike Vinciquerra estimates that while high-frequency traders account for less than ten percent of the NYSE's total net income, the business of co-location is growing and very profitable.

"Colocation we believe could be somewhere in the 30 percent to 40 percent type of margin business today," he said. "It would not surprise me if co-location services became a 50-percent plus margin business as more and more customers enter these data centers."

The exchanges have anticipated these demands. The NYSE's new facility in Mahwah, N.J., is three football fields long and mostly empty—for now.

Beyond the questions of liquidity and location, critics argue high-frequency traders have muddied price discovery by flashing orders for a second or two before canceling almost all of them. Ninety-five percent of these trades are cancelled.

Cronin said the high rate of cancellation makes it difficult for other investors to get a true sense of what supply and demand is for a stock, and therefore what its proper price should be.

"It creates an enormous amount of noise and tax to the system and yet they don't pay for that at all," said Cronin, who advocates charging for cancelled quotes.

This is one of several issues Schapiro said the SEC is looking at in its efforts to bring the market structure up to date with its participants.

The SEC also considering granting special status to high-frequency traders who step in when the markets get rough. Not all high-frequency firms support the idea. The smaller houses feel they would be unable to meet such obligations, putting them at a disadvantage to their larger rivals like Getco and Tradebot Systems.

Another issue the SEC is examining is whether there is any advantage to the broader markets in allowing high-frequency traders to get data from the exchanges that is unavailable to the general public—a public some say will be on the losing side of the investing generation gap until the rules are changed.