High frequency traders under the regulatory spotlight
Simon Maughan is head of product specialists at OTAS Technologies
The regulatory spotlight is shining on high frequency traders and dark pools, but the technological changes that have driven down trading costs for everyone will not be reversed. With market making increasingly the preserve of profit maximising algorithmic traders, there is a growing responsibility on institutions to control where their trades are going and how they are being executed. Those that do not are writing checks to HFTs with clients’ money, writes Simon Maughan.
The problem is simple. Investors are in too much of a hurry to trade and the price of impatience is underperformance. Trading too quickly risks leaving a footprint so large that there is no need to have spent millions on technology to spot this and take advantage. The software exists to analyse the market microstructure and record why it is better to trade different shares at different speeds during the same trading day. The leading software is dynamic, adjusting constantly and using pre trade analytics as nothing more than a starting point for in-trade analysis.
The issue is more complicated and cultural. Portfolio managers make considered investment decisions, taking time to meet a company, investigate its competitors, read its accounts and model its cash flows. An investment committee may even approve decisions. Then the order is rushed to the dealing desk for immediate execution.
Professional investors have a fiduciary duty to take better care of client funds. This means handing responsibility for dealing to your professionals who are in the market every day, while the portfolio managers accept that trading analytics have a role to play in both the timing of execution and the overall expected return on an investment. Heads of Trading need a prominent seat on the investment committee.
In return, traders must upgrade what they do. It is no longer sufficient to spend the IT budget connecting to the algorithms of your favourite investment bank. You must monitor how they are performing, check that they are seeing all the liquidity, slow participation when volume turns out to be unusually large and limit trading when the spread is pushed beyond its normal range. If you do not know what to expect then you cannot differentiate what is significant from what is not. As you trade more stocks it becomes exponentially harder to know whether volume, performance, liquidity and spread are behaving as normal at any minute of the day.
Traders should also consider all the data that litters their screens and ask what they are paying and why. Most likely the answers are too much and for nothing. Dealers regularly complain that the orders on screen are not real and mysteriously vapourise when they reach to hit them. However, these orders are real in one important sense; they are akin to a sonic boom designed to scope out the size and direction of your order and move the market away from you as you rush to complete. If you don’t use the data don’t buy it, but instead spend your money on integrating market microstructure analysis into your platforms, choosing the most complete and visually engaging product.
We frequently hear talk of “running over the HFTs”, referring to sweeping up several layers of bids or asks ticks away from the best market price. In fact, these layers are a trap intended to lure you astray, causing you to buy too high or sell too low. Once your order is complete, the price will return from where it came, lower than where you bought, or higher than where you sold.
If you are measuring dealing using VWAP, you will not spot this problem. Your trader may very well have executed at better than average price while the market was running, but compared with arrival price, your performance is likely to be poor and the reality is that you lost your client money. Optimal schedules exist that will minimize the total costs of trading.
Diving into dark pools to hide your trade means exposing yourselves to whoever is lurking their waiting for you. As the exchanges have responded to pricing pressures by selling more data, it is unrealistic to believe that profit focused alternative trading venues will not do the same, either now or in the future. Lit markets are an important part of the price formation process at the heart of capitalism and you should be confident of what you will encounter should you step away from them.
Market making is just one of the HFTs’ business lines and they are not doing anything illegal. Rather they are earning the returns on heavy investment. There is no need for every buy side firm to undertake this investment as specialist firms exist to do the analysis. Portfolio managers may say that they make investments over the long term, to gain large returns and a few basis points on a winning trade will make no difference. Yet there are good stock pickers at many firms, at least as many as there are outstanding stocks to own, and a few basis points on every trade will make the difference. Furthermore, the manager must contend with inflows and redemptions, placings and IPOs, option overwrites and even trades driven by the risk controller. These must be managed in the optimal way.
Do not be reactionary, invest to control your footprint in the market and stop writing a check to the HFT with your clients’ money.
