Waters Debate: Competitive Edge or Unfair Advantage?

A New York Times article last month sparked a heated controversy over the long-established practice of high-frequency trading, with people weighing in from all sides of the economy. Waters asked some industry players and commentators for their two cents on the high-frequency trading debate.

All Hail Innovation: Defending high-frequency trading.

It used to be the market-makers and specialists who took the brunt of broker complaints that prices were fixed and the market was inefficient. Now, most of them are gone, so high-frequency trading firms are in the spotlight. Making markets is about gathering information quickly and making decisions based on that information faster than the competition. For high-frequency traders, that means seeking out millisecond inefficiencies and trading on them in microseconds.

Before we discuss what high-frequency trading means to the market, it is important to distinguish between the recent outcry against flash orders and high-frequency trading. Flash orders-orders displayed to a limited set of customers in the hopes of receiving price improvement-have been deployed by a few of the equity exchanges, and while high-frequency trading firms do use this mechanism, it amounts to only a small fraction of most high-frequency strategies. Might flash orders amount to front-running? It's a feasible argument, but outside of this particular exchange practice, a high-frequency trading firm responding to information in a microsecond while it takes everyone else a millisecond is not front running-it's just called trading.

So what benefits do the high-frequency trading firms provide? Proponents of high-frequency trading argue that these firms contribute liquidity to the market and therefore create a more efficient price discovery process for the investors. This argument is allegedly refuted by claims that this liquidity isn't "good" or "real." The need for liquidity arises because investors and therefore their orders have different objectives. Because of this, finding a perfect match for every order is difficult if not impossible. High-frequency traders, not to mention many other firms with liquidity-providing strategies, take on risk by stepping in to correct this inefficiency. Waiting for a natural match to every order is good in theory, but no one has that kind of time.

Use of technology comes in a close second to trading style in the argument against high-frequency trading. Some say that their access to the best and fastest technology provides an unfair advantage. This premise is laughable. These firms have invested millions in designing and creating a high-speed infrastructure to execute their trading strategy. Since when was innovation considered unfair? Hundreds of hedge funds, asset managers and brokers have similarly sophisticated technology that they use to execute trading strategies other than high frequency. Is Google being unfair in Internet search because its innovative approach changed the market? No. Neither are high-frequency trading firms.

What about retail investors? Are they at a disadvantage to firms trading with the latest and greatest technology and direct exchange access? The truth is exactly the opposite. If your account is with nearly any major brokerage firm-all of which have access to bleeding-edge technology and servers side-by-side with those of the exchange-then your disadvantage is limited only by your ability to choose the right stock.

We live in a society based on and grown out of capitalism. Being smarter and faster than your competitors, whatever your business, has been a guiding principle of companies worldwide for decades. So why are these ideas suddenly thrown out when it comes to high-frequency trading models that have been around for nearly a decade? No one likes to lose, especially traders, and now that a small handful of relatively unknown firms are making profits in the billions, those not in the loop are crying foul. Am I unhappy that the guy next to me in the commuter lot has a Porsche and I don't? Sure, but that doesn't mean he didn't earn it fair and square.

Kevin McPartland is a senior analyst with The Tabb Group.

A Galactic Battle: How high-frequency trading impacts trading costs and ultimately, citizen savers.

There is currently a galactic battle being waged between high-frequency traders and institutional investors.

High-frequency trading now accounts for the majority of all equity trading, with recent estimates as high as 73 percent. High-frequency trading has driven most market-makers and specialists out of the business of providing liquidity, the lifeblood of an efficient, effective and fair market. Liquidity is what investors buy when they come to a market. Trading costs are the price of liquidity.

In the past, institutional investors, who represent individual citizen savers, could discipline broker-dealers, denying them orders in the future, which served as a balance of power in the struggle for liquidity. Now, the anonymous and electronic markets deny retribution to the investor and shift power to speculators and high-frequency traders.

Institutions need the liquidity high-frequency traders provide, but are probably paying more than they need to pay. The cost is hidden in the price of the shares, not the commissions.

 Commissions, while easy to measure, are only a small part of the total cost of trading. Smart investors look beyond commissions to understand the total costs of trading. The large costs come from front running or scalping on the one hand, and adverse selection on the other. High-frequency traders profit not by commissions but by forcing investors to pay more than they need to pay for liquidity. One analyst firm The Tabb Group estimates that institutional investors incur approximately $23 billion per year more than they should in costs, due to the actions of high-frequency traders.

How can institutional investors find the liquidity they need and avoid paying more than is necessary for it? The answer lies in technologies and tactics, which are just as powerful as the technologies and tactics used against them. Investors are not likely to find the help they need from the large integrated broker-dealers; these dealers are in the business of competing for the order flow of high-frequency traders and in the business of proprietary high-frequency trading themselves. They optimize their trading systems accordingly.

There has been a call for more regulation, but regulation is a blunt instrument and usually lags technology. I do not believe that regulation will provide the solution, and since the issues are basically about costs, regulation may not be appropriate anyway.

Large institutions need to look for new solutions optimized for them. Competitive innovation is the answer. An arms race has been under way for years. The state-of-the-art has changed again and again. The current round is shifting power to investors.

There are new tools that institutions can use to control the trading costs. These new tools predict the effectiveness of different trading tactics and switch accordingly, hide the presence of large orders, use market fragmentation to their advantage, and detect the presence of predatory front running and adverse selection.

These new tools convert market fragmentation from a problem to an opportunity, let investors not only tap liquidity but also hide in an immensely fragmented landscape and reduce the total cost of trading.

Institutional investors, as a practical matter, must now use such tools to trade because the computational intensity required to minimize total trading costs is overwhelming. The new tools are the next logical evolution in managing the complexity and technical sophistication of trading technology and they fill a gaping hole in the typical trader's arsenal.

By actively managing trading tactics and trading venues, these new tools shift the balance of power back to the investor. The predator becomes the prey. They are profoundly important innovations, but not yet well understood.

There is a mismatch between the market structure the US has for equities and the market structure it needs. High-frequency trading is profitable because wholesale trades are being executed in a market designed for retail trades. The structure we have is good for small trades and retail trades but it is inappropriate for wholesale trades-the trades that institutions need to execute on behalf of millions of citizen-savers.

A market structure that addresses this problem is one that combines access to three distinct types of liquidity pools with three sets of rules of engagement, to meet the different circumstances in which institutional traders must operate. These include a wholesale facility for large orders, a facility that harvests liquidity in the retail markets without being seen, and a facility that allows investors with liquidity resident in their blotters-that is, not yet committed to trade-to trade together.

Early adopters are finding 30 percent to 40 percent reductions in total trading costs.

More importantly, a few sophisticated institutions recognize the value of supporting a counter-balance to the high-cost market structures that force institutions to pay too much for liquidity.

We believe these are highly disruptive innovations that threaten the traditional business models on Wall Street. They are unrecognized as such now, but this will not be the case in a few years.

Al Berkeley is chairman of Pipeline, which operates the Pipeline alternative trading system.

Level the Playing Field: The fixed-income market provides insight into how the equities world could be.

Is high-frequency program trading inherently unfair? Does it improperly utilize technological advances? Does it allow front-running at the point of execution? So many great questions, but to this point, the debate on this topic has completely focused on the equity markets.

Well, let's shift the focus of this debate to the debt markets, commonly regarded as the bond or fixed-income markets. What can we learn by comparison? Do the fixed-income markets represent a fair comparison? As with any comparative analysis, do we have sufficient data to analyze and compare these markets? The debt market across all sectors totally dwarfs the equity market in terms of size. Let's frame the debate.

I view technological developments on the investment superhighway as having three lanes: analytics, risk management, and trade execution.

Whether in fixed income or equities, technology that more efficiently and productively provides robust analytics is a great advantage and should be embraced. As a case in point, when I traded mortgage securities throughout the 19880s and 1990s, Bear Stearns invested in and utilized tremendous analytics. The Bear system was so advanced that it could literally analyze the mortgages in a mortgage-backed security to the level of the underlying zip code. No other dealer had those capabilities and it was a boon to Bear's business. This technology was utilized to run a wide array of customer portfolio optimizations and helped Bear become the top mortgage shop on Wall Street. Bear's downfall is a story for another time. The point is that technology that can more thoroughly review an investment product promotes competition and capitalism. There should be no speed limit on this technology lane of the investment superhighway.

The second technology lane on the investment superhighway entails risk management. When trading at First Boston, I and every other trader manually monitored our own risks, whether those risks were interest rate risk or credit risk. Management had no ability to view the overall risks across the entire fixed-income division on a real-time basis, meaning at any specific moment in time. To say that First Boston was inefficient was a gross understatement. When I went to Bear Stearns in 1990, I was blown away by the robust real-time risk management system. A trade from point of execution to entry into the system to updating my risk profile was literally a matter of a few seconds. What were the results? I could trade greater volume with greater confidence knowing exactly where my risk stood. There should be no speed limit on this technology lane of the investment superhighway.

The third technology lane on the investment superhighway entails trade execution. The fixed-income market, much like the equity market, had traditionally been a person-to-person executed model. That process changed dramatically over the last decade with the development of a platform known as Tradeweb. This company was launched with equity capital provided by a consortium of Wall Street dealers. Tradeweb has revolutionized the business. Having started by executing trades within the US Treasury market in 1998, Tradeweb now globally engages customers and dealers. Tradeweb executes trades across a wide array of market segments, including: a variety of interest rate products, the US mortgage market, the corporate bond market, the credit derivatives market, and money markets.

Tradeweb not only engages in trade execution, but is also fabulous at trade settlements and thus risk management.

Let's zero in on Tradeweb's trade execution because this is where the rubber meets the road-no pun intended-in comparative analysis with high-frequency program trading activities in the equity markets. Tradeweb allows fixed-income investors to engage Wall Street dealers across all of the aforementioned markets with trades executed within a matter of mere seconds. The playing field is completely level as dealers enter price levels, stand by them, and execute trades. If a Wall Street dealer is delinquent in responding to an investor inquiry, so be it.

Were Tradeweb to allow one dealer to see another dealer's price level or allow dealers to instantaneously flash price levels without obligation of standing by their price, there would be hell to pay. Why? If dealers and investors knew that certain entities were provided preferential treatment by Tradeweb, then there is no doubt in my mind that Tradeweb would be out of business tomorrow. Make no mistake: The speed limit on the trade execution lane of the investment superhighway is extremely fast. How fast? Trades are executed within a matter of a few seconds. It works just fine for the hundreds of billions in daily volume compared to the relative odd lots traded in the equity market.

I strongly believe in and embrace technology. I also have a soft spot in my heart for fundamental fairness and integrity. I think all global equity exchanges should implement fixed-income trade practices. I believe they are the best of both worlds. n

Larry Doyle is a 26-year Wall Street veteran and author of the blog Sense on Cents. -->