Members of Canada’s alternative investment industry gathered two weeks ago in the swishy, plush confines of the National Club for the 11th annual debate hosted by the Alternative Investment Management Association. The debate is a great annual tradition. The National Club was founded in 1874 as a home for Canada First, an old nationalist movement that sought to “promote a sense of national purpose and to lay the intellectual foundations for Canadian nationality.” The spot seems appropriate for the intellectual journey the AIMA debate provided.
On tap for discussion here in 2014 was an issue that has become the debate du jour of the last year, “High Frequency Trading, Good or Bad?”
Over the last several years a new industry niche has opened up for companies that apply high speed trading technology to generate profit. Firms that use super-fast computers to get “in front” of the order queue at stock exchanges program these computers to “trade against” order flow. Human traders trying to read market demand have no chance of understanding what’s going on. The high frequency traders have been able to pile up bundles of money by making millions of tiny bits of profit (often just a couple basis points a trade) at digital speed. So lucrative has the practice become, some companies have taken to locating servers as close to stock exchanges as possible as a way of being the “first in line.” Others are paying huge sums to profit-hungry exchanges to get the fastest connections. These practices have outraged some. Manipulating the underlying physical structure of markets to make money is unethical and immoral they claim. Traders are relying on the structure of markets to make a profit, are no longer trading on the basis of the underlying securities. This is eroding the key market making and price discovery functions. Market sanctity has been eroded. Or so goes the argument. The AIMA debate took up this key question. What followed was one of the more intelligent, informed debates on an issue that has largely been mishandled in the mainstream press.
Arguing the pro-side of the HFT debate was Doug Clark, a 20-year veteran of the Canadian financial services industry. An original member of trading firm ITG Canada, Doug is currently responsible for researching index, ETF, market structure, liquidity events, and market impact at the firm. Prior to joining ITG Doug ran the program and electronic arm of a large Canadian bank, traded proprietary equities and derivatives for a large Canadian trust company, is former chair of both the Canadian Security Traders’ Association, as well as the Ontario Securities Commissions’ Market Structure Advisory Committee. That is, he knows a lot about the ins-and-outs of the modern Canadian stock trading system. He is a proponent of high-frequency trading, and explained why.
“There’s lots of mispricing in markets. HFT has to be credited with tightening spreads,” said Clark, citing the example of stocks that are inter-listed between the New York Stock Exchange and the Toronto Stock Exchange. In the late ‘90s inter-listed stocks had a spread of five to six cents. Post HFT, “The spread between New York and Toronto is now one second,” he says. Clark went on. HFT has been important to the rise of the exchange traded fund, or ETF. Exchange traded funds depend on traders to keep the funds honest. By trading against the differences between the S&P index and the cash basket maintained by the fund company (and that ‘mimics’ the S&P) the value of exchange traded funds are “kept in check.” Or, says Clark, “HFT makes sure that the retail…the captive traders…get a fair product. Who else would be creating tight spreads between ETFs S&P 500 and the cash basket?” Good point. HFT also ensures that makes sure banks around the world trade against each other in a relative manner. HFT strategies link various similar stocks around the world (that is, similar securities trade in a more correlative manner) than would otherwise be the case. Pockets of volatility around the world are linked. Overall markets become more efficient. “We’re linking liquidity. HFT strategies link volatility. Who would be doing this? Today, the marginal flow [that reduces mispricing] comes from HFT,” says Clark.
He admitted there were some issues to iron out around HFT. “There are too many order types [which HFT firms exploit] …and there are some bad actors. Go after those. But we bring liquidity to the market. This reduces mispricing, and that’s good. We need to make sure not throwing baby out with the bathwater [by enacting reforms on HFT],” said Clark.
And so everyone enjoying lunch seemed convinced HFT was God’s gift to markets. Then Peter Berdeklis, a portfolio manager and head of algorithmic trading at Maple Financial, spoke to the con side, shifting opinion again.
Peter has 16 years’ experience as a portfolio manager and proprietary trader Canadian trading desk at Maple. In 2000 he joined National Bank Financial as a proprietary trader specializing in statistical arbitrage and U.S. convertible arbitrage, and was later a managing director with the global equity derivatives group of National Bank, where he developed the proprietary algorithmic trading platform that was used for trading, electronic arbitrage and market making. He founded Context Switch Consulting in 2009, a firm focused on developing algorithmic trading systems for high frequency trading. He rejoined Maple in 2010, where he runs a proprietary trading desk focused on high and mid frequency statistical arbitrage. If all this sounds confusing, it is. It helps if you, like Peter, have a Ph.D. in Physics from the University of Toronto.
Berdeklis argued that the rise of HFT trading has eroded market fairness. Human market makers are packing it in and leaving the profession. “Those who depend on the underlying trade, not execution, have taken over markets. Traders have been leaving markets in droves as a result. Active traders are always on the losing side against a computer. The relatively low levels of volatility recently are the result…There are fewer active traders than there was in 2006. Look at how low market volatility has dropped. Look who’s leaving the table. Market makers are….These guys have been working for a 100 years. These guys are not working today,” said Berdeklis.
HFT computers, of course, can thousands of signals to the market each second. No human can keep up. The human will always be beat by the computer. “This is the secret no one will admit. This is the industrialization of adverse selection.” (Adverse selection is a technical term for a situation where sellers have information that buyers don't). According to Berdelkis, the ability to do this stuff is now being confined to the biggest firms, “It is now $700,000 a year for the connections through the best pipes.” He goes on to explain that some firms are using Microwave co-location—putting their computer closest to the market computer—as a way of gaining a few thousands of a second in trading speed. “It’s one more step in implementing this adverse selection. The small firms can’t compete, so they’re leaving the table,” he says. “Don’t forget that it was Bernie Madoff who pioneered this model. Selling order flow to HFTs is now common. Uninformed trade flow is being preyed upon by the big rich traders who can always, because of pure technical reasons, get in front of that order flow.”
As it is, the most egregious forms of this kind of trading are Illegal in Canada. And some rules are now being reviewed in the US. But this is, says Berdelkis, “adverse selection on in industrial scale…this is a structural issue. Businesses have structured this over years. But it is fundamentally unfair…it is parasitic. We need a review of order types that give advantage to HFTs. Our regulation have been lacking on this. It’s especially rampant in the US.”