Sense on Cents

High frequency trading activity has become a very hot topic both on and off Wall Street. My trading instincts tell me that this activity is not productive for the long term health and well being of the market. I have referenced the work of Joe Saluzzi and his colleagues at Themis Trading in making the case for the prosecution.

In an attempt to present a case for the defense, I searched and found commentary written by Sang Lee, managing partner at Aite Group. Lee recently wrote for Advanced Trading, In Defense of the High Frequency Trading Community:

Various potential regulations, including the reinstatement of the uptick rule and transaction tax directly threaten the business model of the high frequency trading community.

Sense on Cents counterpoint: The uptick rule required short sellers of stock to only transact at a price higher than the previous trade. Our friendly Investing Primer, Investopedia, informs us:

This rule was introduced in the Securities Exchange Act of 1934 as Rule 10a-1 and was implemented in 1938. The uptick rule prevents short sellers from adding to the downward momentum when the price of an asset is already experiencing sharp declines.

The rule worked fabulously for almost 70 years before being discontinued in July 2007. It was discontinued in an attempt to promote trading volume on the exchanges and in turn increased fees.

Sang Lee writes further in making his point:

In recent years, growth of alternative electronic trading venues has been driven by a multitude of factors: the introduction of decimalization; the adoption of FIX as the main protocol for electronic communication; the availability of technology for developing market infrastructure conducive for electronic trading; the rapid adoption of electronic trading; the adoption of algorithmic trading; and the availability of co-location services.

Sense on Cents counterpoint: Fairly obvious with all of the technological advancements that we are not looking at your grandfather’s “buying 100 shares of IBM.” Modern day trading activity is both fast paced and high energy. Little wonder why it has become so much more driven by technical analysis than fundamental valuations.

Having laid the foundation of recent structural developments within the market, Lee launches his defense of high frequency program. His point:

All of these factors have also created a fertile ground for the exponential growth of the high frequency trading community. The high frequency trading community, in turn, has added significantly to the increased volume in the market. It has also taken part in improving market quality, as defined by increased liquidity and tighter spreads.

Sense on Cents counterpoint: Lee is entitled to his opinion, but I beg to differ on his taking credit for tighter spreads. The fact is the exchanges moved from fractional pricing (trading in 1/8ths, that is .125) to the aforementioned decimilization (trading in pennies, that is .01). High frequency trading followed the change in pricing, rather than having led it.

Lee continues to make his point:

In today’s highly electronic trading environment, high frequency trading firms play the role of liquidity providers, very much like the traditional market makers and specialists of the past, just without the perception of conflict of interest and information advantage. In other words, someone has to be paid to provide liquidity into the market, and the high frequency trading community represents the next evolutionary group to do so.

Sense on Cents counterpoint: I again beg to differ. Lee believes high frequency traders provide liquidity which benefits the market overall and especially smaller investors. The fact is the exchanges developed a small order exchange system, or SOES, which facilitated the execution of small orders.

Lee maintains high frequency traders led these developments, while I believe they followed them.

He finishes his case for the defense of this activity. His point:

Now, in an era of increasing regulation, industry buy-in is a must, and careful considerations and input from all key segments of the financial services industry will be critical in stabilizing the marketplace. Failure to do so may lead to unintended consequences that could cripple the marketplace, such as a short-selling ban and the proposed transaction tax potentially leading to drastic decline in overall trading volume.

In the past, the market faced many challenges, including lack of market transparency, unreliable price discovery mechanism, wider spreads, and skewed market forces that favor specific firms with an unfair information advantage. High frequency trading firms have addressed all of these issues through the development of smart trading models and innovative technology, and have essentially leveled the playing field for everyone in the marketplace. In the end, high frequency trading firms should be viewed as a by-product of market evolution that have taken up the critical role of providing much needed liquidity into global financial markets.

While he now admits high frequency trading is a by-product of the technological developments both on the exchanges and within firms, Lee continues to mistakenly believe they promote liquidity.

Liquidity is provided by traders who make obligatory markets for certain sizes and stand by them. These high frequency traders are high volume scalpers taking advantage of order flow. Unlike traders who are obligated to make a market and stand by it, high frequency traders have no such obligation, and will use order flow to their advantage.

The markets experienced this activity on a much smaller level shortly after the development of the SOES sytem. High frequency traders are nothing more than current day SOES Bandits operating on a very large scale.

While the ‘bandits’ ride roughshod through the financial community, every other investor is getting clipped in the process.

I rest my case.

Please let us know, “Do you have a verdict?”

LD

This entry was posted on Friday, July 17th, 2009 at 6:12 PM and is filed under General, high frequency trading. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.