June 2014

INSIDE VIEW: Reflecting on flash boys

Wall streetInstitutional investors have long been aware of the negative effects of high-frequency trading and have traded large size orders in HFT-free zones for some time, says Mark Pumfrey, of Liquidnet. Michael Lewis’s book Flash Boys has definitely pushed the high-frequency trading (HFT) debate into the mainstream. And while the book has undoubtedly acted as a good catalyst for a broader discussion on the role that HFT plays in today’s markets, to think these issues have taken institutional investors by surprise would be misguided.  That some investors are hugely disadvantaged by placing their orders in the so-called lit markets is not news. It is a phenomenon that has been taking place for years. The impact this has had on the market over the past few years has been essentially a “HFT tax” on the millions worldwide who invest in pensions and mutual funds. That being said, not all HFT is bad. Some market makers that use HFT techniques can bring liquidity to the retail market. They have contributed to lowering the cost of trading for retail investors, by using the process of disintermediation to reduce the margins that brokers charge. However, there are some HFT strategies that use the same tools – technology, speed, co-location and other advantages – but with the intent to profit from price discrepancies from large institutional orders. PREDATORY STRATEGIES
These predatory trading strategies do not contribute to liquidity, given the often deliberate confusion between liquidity and volume.  This type of trading adds volume to the market, but this does not necessarily equal liquidity, and nowhere is this difference between volume and liquidity more obvious than in the equity markets.  The market has evolved to favour small orders, versus large orders. For example, the average institutional-sized order in the US is about 250,000 shares, but the average execution size on public trading venues is only around 250 shares. As this trend has continued to develop, institutional investors have learned to adapt and have found ways to trade in large size and interact directly with each other to avoid becoming prey to predatory HFT strategies.  Institutions are increasingly choosing to trade away from the public or “lit” markets, on specific institutional trading venues. Non-displayed liquidity venues have become the preferred execution venue among large institutional investors who want to avoid slicing their orders into smaller sizes. Our experience as a block-trading facility shows us that institutions have an acute need to trade in block sizes and this is demonstrated by the fact that on Liquidnet, trade sizes are more than 100 times larger than any other exchange or dark or lit pool.  Concern around the impact of HFT was highlighted in our recent Institutional Voice Survey when more than half of the institutional traders who participated in the study said they believe that controlling the effects of high frequency trading (HFT) should be high on regulators’ to-do lists.  Traders also indicated that they are actively changing their trading behaviour to mitigate the impact of predatory trading strategies. This includes, taking more control over where their orders are executed, being more cautious about protecting trading information, and using off-exchange and HFT-free
trading venues. SENSIBLE DEBATE
The survey also found that market impact costs (59%) and information leakage (43%) were among the most important considerations. So where do we go from here?  While we cannot turn back the clock and uproot predatory trading strategies altogether, we can have a sensible debate about the flaws that exist in the structure of markets and try to agree on ways to fix them.  Those problems can be grouped into two areas and are fundamentally concerned with choice – the choice of who is on the other side of an institutional investor’s trade, and what type of platform they trade on. In the lit markets, investors have no choice about whether they interact with HFT flow or not. Traditional market makers are retreating from equities trading to be replaced by HFT market makers. These entities can give and take liquidity at will, having no client relationships to maintain or overnight exposures.  This behaviour does not breed confidence. While the solution is not to make HFT more heavily regulated than other aspects of the market, investors should have the choice of whether they want to interact with it or not. The other part of this problem is concerned with the forced co-mingling of retail and wholesale markets. We have a situation in which those who buy large amounts of shares and those who buy small amounts, continue to interact on the same venue. This situation is like no other industry I can think of. The consequence of this is that the market is inefficient, it damages the ability of institutional investors to execute their orders, and, when predatory strategies move against institutional orders, it can damage their investment performance.   At the very least, Lewis is making everyone with an interest in the investing industry take a long hard look at themselves, something which can only be a good thing.  With money starting to flow back into equities, now is the right time to capitalise on this positive sentiment and to think about the future of the equities markets, and institutional investor participation, and work to create a level playing field for everyone.  This debate must be framed by a simple question: Is our economy better served by a market created for traders or one for investors? We have a responsibility to try to restore investor confidence and to do so it is essential that we go back to the original purpose of the markets – to promote investment, capital formation and wealth creation. Mark Pumfrey is head of Liquidnet in Europe, the Middle East and Asia ©2014 funds europe

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