Moves by stock exchanges to invest in system upgrades to accommodate high-speed trading have been likened to an arms race that threatens to destroy value and undermine market integrity.
Striding into the technological warzone is Seth Merrin, president and founder of Liquidnet, an institutional buy-side venue whose clients seek to trade in large blocks (too big for most HFTs).
Merrin argues that recent trading glitches – such as erroneous orders by market-maker Knight Capital and the Nasdaq delay on Facebook’s IPO debut – underline the inherent risks as exchanges upgrade their systems to drive higher HFT volumes and fees.
“With exchanges and brokers catering to high-frequency trading, it is becoming an arms race,” says Merrin. “Trading systems are being upgraded for a few millisecond speed advantage, leading to glitches like Knight Capital. This does not serve to help investors’ confidence and, if not properly tamed, could create weapons of mass destruction.”
Facebook’s market debut this May saw Nasdaq caught out by a torrent of trade cancellations that kept interrupting the system from completing the opening auction and resulted in a 20-minute trading delay – and losses to Nasdaq as it compensated for losses suffered by market-makers.
Meanwhile, Knight Capital suffered a pre-trade loss of $440 million after its algo sent an aberrant order onto the New York Stock Exchange, causing wild swings in over 100 stocks and the exchange to cancel trades in six stocks on August 1.
Merrin says such glitches, following on from the flash crash of May 6, 2010, are prompting investors to pull money out of equities markets again.
His point is that it is turning into a counterproductive spiral. Exchanges are under competitive pressure to boost trading volumes and revenue, and are responding by increasingly catering to high-frequency traders that are flooding their systems with messages (rather than orders).
Merrin argues that cutting execution to milliseconds through technology and infrastructure such as co-location is catering to the “lowest common denominator”.
“Exchanges are placing a lot of effort behind a group of traders, not investors, that may pay them a lot of money and fees but actually do nothing for market integrity,” he says.
While he acknowledges that not all high-frequency strategies are inherently disruptive – some are seen to provide liquidity and price discovery – there are those seeking to profit by exploiting supply-demand imbalances in the market.
He fears it is their prevalence that is potentially destructive to the market structure, creating profit for a few at the expense of many.
Lee Porter, Liquidnet’s Asia-Pacific managing director, notes Asian exchanges are facing a drastic decline in listing fees given the present environment. While exchanges in general strive to operate a neutral marketplace, they face a conflict as they turn to new revenue sources.
“Historically, a big portion of their customer base is institutional and retail investors,” says Porter. “Such balance has shifted as you can see in the US; HFT accounts for 60% of overall market volume as represented by trading – a buy and a sell in milliseconds for a profit. These volumes do not represent fundamental investment anymore.”
Clearly, high-frequency trading is not going away. But while Asian regulators such as those in Australia, Hong Kong and India deliberate over new regulatory frameworks to supervise electronic trading, Liquidnet has been appealing to exchanges to give investors an option.
“Even if an exchange decides to cater to high-frequency trading strategies, investors should be able to choose whether and when to interact with them, they should not be forced to interact with high-speed traders,” states Merrin.
He says the risk is that investors lose confidence in the markets, fearful they will be taken for a ride by another trading glitch. This would affect the ability of companies to raise funds via IPOs and so destroy an exchange’s fundamental function as a conduit for capital formation.
Globally, Liquidnet operates in 41 markets; at present 230 asset managers that use its service are trading Asian securities, half based in Australia, Hong Kong and Singapore. Merrin says it aims to get 50% of the group’s revenue from Asia and Europe within five years, from 30% now.