The information flow in capital markets has come a long way since a private intelligence envoy informed Nathan Rothschild of Wellington’s victory over Napoleon at Waterloo a full day before the British government (who expected Wellington to lose), whereupon Rothschild legged it down to the stock exchange and used this information to enhance his already considerable fortune.
In the modern capital markets, Rothschild’s 24-hour window of opportunity to get ahead of the market has, with the aid of computers, been compressed into milliseconds. But as new marketplaces have emerged, ordinary PCs have been unable to compete with Wall Street’s computers. Powerful algorithms – or ‘algos’ – execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can think, changing orders and strategies within milliseconds.
This technological tsunami has begat high-frequency trading (HFT), something that, depending on which side of the argument one falls, is either the blinding future of capital markets, or the latest example of Wall Street bilking Main Street.
“Institutional investors are deeply divided over the merits or otherwise of high frequency trading strategies,” says Jay Bennett, consultant on institutional equity investing practices at Greenwich Associates, who last year co-authored a report on HFT.
One of the questions Mr Bennett asked in the report was: Do you feel your firm’s trading operation is disadvantaged due to other institutions’ use of high-frequency trading practices? In answers back from 78 institutional investors in the US, Canada and Europe, Mr Bennett and
his co-author John Colon found that institutional investors are deeply divided over the merits or otherwise of high-frequency trading strategies. The result was 55 per cent answering ‘no’ and 46 per cent for ‘yes’.
“Our report revealed a complete lack of consensus about HFT’s role in equity markets,” says Bennett. “The institutions are utterly split between those who see HFT as malevolent or benign, as adding liquidity to global markets, or preying on traditional stock investors.”
But many have said the success of HFT is based on the speed of the technology. “If your computer takes more than 50 milliseconds to execute, then you are a dinosaur in this business,” says Joseph Saluzzi an expert in electronic trading who co-heads the trading desk at independent agency brokerage firm Themis Trading.
“High-frequency traders claim to be market makers and they claim the liquidity they add to the market has lowered volatility and helped narrow spreads. But the problem here is, unlike a traditional market maker, they have no requirements – no minimum size to display, no minimum time to display a quote and no capital commitment to a client.”
And not only is the speed of the computer important, but also the code driving the computer has become the new industrial espionage of the financial markets. In July last year, it was reported that a computer programmer at Goldman Sachs called Sergey Aleynikov was arrested for stealing 32MB of proprietary algorithmic trading code for the firm’s high-frequency trading program.
“While none of us knows the ingredients of Goldman’s ‘secret sauce,’ we can say that any algorithmic code in and of itself is precious, but has limited value until placed in the right circumstances,” says Robert Iati, partner at TABB Group, the financial markets research and strategic advisory firm. “Those circumstances are not available to just any Tom, Dick or Sergey, but represent the core strategy of the fast-rising high-frequency trading firms.
In an article Iati wrote for Advanced Trading magazine in July 2009 (which attracted a lot of industry attention), according to TABB Group’s research, high-frequency trading firms – which represent approximately 2 per cent of the 20,000 or so trading firms operating in the US markets today – account for 73 per cent of all US equity trading volume.
“These companies include proprietary trading desks for a small number of major investment banks, fewer than 100 of the most sophisticated hedge funds and hundreds of the most secretive prop shops, all of which operate with one thing in mind – capture profit opportunities by being smarter and faster than the closest competition,” says Iati.
Mr Iati’s rubbishing of the theory that one company’s HFT code falling into the hands of another will immediately give that company a competitive advantage is echoed by Andy Raby, head of customer services at Halifax Share Dealing, one of the largest execution-only brokers in the UK. “It’s important to note that high-frequency trading algorithms don’t work in all circumstances,” he says. “And to suggest they do simply doesn’t reflect the reality of the structural complexity of the stock market and the way equity prices are formed.”
Unlike the reaction to HFT in the US – especially the sellside – the buyside community in the UK seem pretty unfazed by HFT. Several very large UK asset managers were approached for comment on HFT for this article – companies with tens of billions in both retail and institutional funds, companies who regularly buy and sell huge chunks of stock on behalf of their clients – all felt the subject unworthy of comment.
“Doesn’t really affect us,” said one. “Just the Yanks getting their knickers in a twist,” said another.
But one of the ‘crimes’ many in the US accuse high-frequency trading of committing is the reduction in costs and the generation of enormous profits for these sellside firms – but that buyside investors lose out in terms of being landed with higher trade execution costs and consequently lower investment returns. But how true is it?
“Do the high-frequency traders make enormous profits at the expense of retail customers?” ponders Halifax Share Dealing’s Mr Raby. “No they don’t. Most retail customers will not trade directly with the stock exchanges; instead, they request quotes from market makers via their broker’s systems.
