Lately, in the aftermath of the Flash scandal, as more and more attention has been vested into broader market landscape issues such as High Frequency Trading, there has been a spirited defense of HFT, which traditionally goes along the lines of: if it provides liquidity, it tightens spreads, it must be good. Just look at the NYSE's own blog for a version of this.
Yet, is it as simple as that?
In an interview with Advanced Trading, Seth Merrin who is the founder of Liquidnet, the largest buy-side only dark pool, provides some salient arguments for the contra view on HFT.
Before getting into HFT, Seth is quite vocal in his condemnation of Flash orders:
While high frequency trading as a category has its pros and cons, like all trading, but flash orders have absolutely no pros, says Merrin, an advocate of the institutional investor.
This is an example where again— typical of Wall Street— there are a few that benefit at the expense of many
Whenever there is a crack in the armor or someplace where you can make a lot of money, Wall Street figures it out very quickly and that's where they go.
While flash orders are used to give a sneak peak at order flow to participants on a private network so they can match a trade before routing out to a public market, Merrin says this is no different than an institution giving an order to a broker and finding out that the broker relayed the order to different hedge funds. "What would you do with that broker?" asked Merrin.
The last statement is actually very pertinent, as it indicates substantial analogies that can be extracted between a generic critique of Flash orders, and how bond and CDS sales and trading desks operate when providing staggered looks for order flow to preferred clients (while their own prop traders who sit feet away (and have first dibs on every bid and offer) are consistently privy to every nuance of overall trade flow). In fact, this will be a major focus point on Zero Hedge soon as we demonstrate some historical and concurrent findings in something as simple as the physical layouts of Broker-Dealers' trading floors (particularly those who have a prop trading operation), and how physical proximity with Chinese walls absence, provides BD's with the potential to make off like bandits by trading wide-spread Fixed Income products, without any regulatory intervention. One argument is that the contemporary Chinese Wall should be erected not between the Sell Side and Corp Fin, as nobody cares what sell side researchers have to say anymore. It should be between Flow and Prop traders at major investment banks-BHC's-government backstopped hedge funds. As for Merrin's question of what one would do with such a broker - the truth is that in the aftermath of the Lehman and Bear collapse, institutions have very few options in deciding who their primary relationships are with, especially since secondary inventory is focused at a very few key B/D's.
Continuing with Merrin's observations, he moves from a uniquely negative opinion of Flash to a muted one on HFT:
Of greater concern to Merrin is the idea that high frequency trading has become the majority of the market. According to Merrin, there haven't been enough studies done on the impact of high frequency trading, which has become the majority of the market. "What we have to recognize is that the market shifted in the last two years very significantly," he said. Traditionally the market has been made up of retail investors, institutional investors and market makers that facilitated these investors, he continued. "Today you have a whole new category which is high frequency trading, now making up 70 percent of the trading in the market according to some analysts," he noted. Two years ago, it was only 30 percent of the trades, so there's been a significant shift, emphasized Merrin. What's more, venture capital firms are funding the start- ups of high frequency trading houses, he noted.
So we've shifted from an investor's market to a trader's market," said Merrin. "Clearly that has implications that people have to understand and think about," he said. He compared what's happening in equities to the commodities markets, where a bunch of energy traders moved the price of energy, not because of supply and demand factors, which is what usually moves commodities prices, but because of speculation.
"There could be a fundamental disconnect between the investor who takes a look at the fundamentals of the company or the industries they're investing in and the second-by-second traders who simply take a look at what's going on in that trading range. If the disconnect happens, that is going to affect how the rest of us, the institutions and the retail investors can invest going forward."
And this, ladies and gentlemen, is a well-phrased summation of numerous concerns against the implications presented by HFT: in its ubiquitous creep to market topology domination, over the past several years, the market has shifted from one rewarding fundamental (and technical) analysis and a long-term vision of equity appreciation, to one which benefit only and exclusively short-term (intraday) speculation. Is it any wonder why the bulk of funds end each day in a 100% cash position and why only gamblers find relish in the casino the equity markets have become? Buy and hold is dead, but not for the reasons Warren Buffet would like you to believe.
As to the liquidity provisioning and spread tightening argument? Merrin had this to say:
While industry analysts have said that high frequency trading is the next evolution of market making and adds liquidity to the equity markets and has narrowed spreads, Merrin said he would not put high frequency traders in the same category as market makers. He offered the example of Nasdaq having 4,000 listed securities, but ECNs are effective in the top 300 names. Still, the industry needs market makers in the bottom 3,700 names, he said. "High frequency trading is primarily in the largest most liquid names. What we need is capital provided in the least liquid names. They can't make money in the least liquid names. So are they providing the same services to the market as market makers?" asked Merrin. "The answer is no," he asserted.
Additionally, high frequency traders are not subject to the same regulatory structure and rules where they are required to make markets. "They go where the liquidity is and the opportunity is and they leave where the opportunity is not," said Merrin.
From this perspective, the whole liquidity provisioning argument is not merely flawed but highly hypocritical - HFTs are like rogue scalpers that move from stock to stock (check out the post yesterday about 5 names accounting for 30% of the NYSE's volume), where the liquidity is, in effect removing liquidity from where it actually needed, until such time as there is no incremental capit6al that can be extracted, and subsequently moving on to other sectors. And all this occurring without any regulatory capital or risk requirements of HFTs, pretending to be market makers.
Granted, Merrin's partiality and his professional afiliation shows when he discusses dark pools and the need for dark liquidity:
As regulators examine some of the changes in market structure, Merrin said what he's afraid of is that they could say to get rid of dark pools, without understanding the benefits of dark pools. "Our job is to create a safe environment for the institutions," said Merrin, who operates the largest institutional pool of liquidity for buy-side institutions to trade anonymously to reduce market impact. Having one central pool of liquidity where everyone has to go and trade, is not conducive because there are too many competing interests in one location, he insisted, adding that's why there is a need for alternatives.
Indeed, dark pools have provided many benefits to liquidity seekers over the years. One is the gradual phase out of VWAP algorithms in open markets in favor of child order algo execution in dark pools (alas it is still prevalent: we reference the numerous posts on Zero Hedge indicating VWAP reversion day after day, especially in light of disappearing market volume). Yet, several potential abuses of advance looks linger in dark pools, such as actionable IOIs and other market tiering mechanisms, which as in the HFT case, present the case of a developing scenario where the "privileged" few benefit from the numerous others. And as Merrin concludes of HFT, the same can be noted about virtually all other verticals of the contemporary market landscape:
"The more money that's chasing this high frequency trading, the more they're going to have to do it at the expense of somebody else, and I'm just afraid that expense seems to always come out of the institution's pocket."
And in the spirit of keeping informational context alive, we present the fact that Liquidnet's own control of institutional trading has collapsed by over 22% year over year (34% for July). We would not be surprised if their market loss is the gain of such dark pools as Sigma-X. Zero Hedge will attempt to discuss this angle with Seth in the near future.
The challenge before regulators, politicians and anti-trust commissioners with regard to all these very salient issues is greater now than it has ever been in the history of a "free and fair" equity capital market. Whether the approach taken is one that will perpetuate the dominance and the increased profitability of a select few or will bring back a sense of democracy and remove the highly speculative element Mr. Merrin discusses, will be critical for the future of US capital markets, and the participation of retail investors in what was once the only way to reward success and punish failure. But then again, the last two seem to be no longer a key concern for the administration, which has taken a sharp detour from the primary tenets of the capitalist system that over the past 200 years managed to make America the greatest country in the world. We hope the right choice is made for the sake of continuing America's greatness, even if it means one quarter where a company like Goldman Sachs has more than 2 trading days of capital loss.