Sense on Cents

There is no doubt that the 21st century will be driven by new and dynamic growth in technologies. Within the financial industry, Waters is a leading periodical focused on the intersection of finance and technology. From their own website, we learn:

Waters, now in its 15th year, looks at how technology is driving the securities industry and how the evolving market structure worldwide is driving technology.

Since its launch in 1993, Waters has been relied on by financial technology professionals worldwide for focused, in-depth coverage of financial market data and technology. The financial services industry spends more on technology than any other. Banks and investment banks — whether global or regional — rely on technology to help keep their traders ahead of the competition. As firms trade up their systems, Waters defines the challenges that the top global financial services confront, be they old school issues like trading room systems and operations or new business propositions like consortia portals and e-commerce spin-offs.

In the August issue of Waters, there is an interesting debate focused on the highly charged topic of high frequency trading. This article, “Waters Debate: Competitive Edge or Unfair Advantage?”, engages Kevin McPartland a senior analyst with the Tabb Group, Al Berkeley chairman of Pipeline, and a Wall Street veteran who writes at Sense on Cents.

For those interested in the topic, I strongly encourage you to read the entire piece. For those interested in the SparkNotes assessment, I provide the concluding paragraphs.

Mr. McPartland, a 10 year Wall Street veteran, writes in defense of high frequency trading under its current construct:

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.

Mr. Berkeley, a 30 year Wall Street veteran, weighs in for changes in the structure of the equity markets:

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.

Your resident host at Sense on Cents, a 23 year Wall Street veteran, opines that the equity markets should embrace a fixed income perspective to electronic trading:

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.

I thank Waters for the opportunity to add to the discussion and debate on the high frequency trading topic, which is certainly not going away.

LD