High-Frequency Trading Winners and Losers (WSJ)

The Wall Street Journal’s “What's Behind High-Frequency Trading” provides a pretty good Q&A on how Goldman Sachs (GS), Citadel and various smaller specialty firms take advantage of advanced peaks at orders, exchange rebates and flash orders that can be withdrawn in a split second. A political furor is starting to emerge from highly leveraged firms front running orders and teasing prices fractionally up at the expense of mutual funds and other large institutional investors.

With firms jockeying for the closest physical proximity to the exchanges data centers, NYSE Euronext (NYX) is building a huge data center in New Jersey to accommodate them. The exchange will be renting space in its own multi-football field size data center to house the computers of high-frequency traders. That’s how critical the speed of light along fiber optic cables is to this form of making money.

Aside from some inherent unfairness, what has regulators and politicians concerned? First is leverage, especially with the small firms specializing in this extreme form of programmed trading. Second is the systemic risk of large trades gone wrong. Third is the cascading effect of copy cat strategies. Think of how seriously flawed the portfolio insurance schemes of the 1990s were when they encountered a few black swans.

While mutual funds and large institutions are marginal losers, the exchanges are obvious winners with increased volume. Typically institutional traders don’t use limit orders for fear of tipping their hand, so any market manipulation hurts their clients. In a very real way high-frequency traders, such as Goldman, are trading against their own clients.

The story is mixed for retail investors. Most firms no longer charge higher commissions for limit orders, so higher volatility increases the likelihood that retail orders will be filled. Investors that are not pressured to buy or sell in a certain time frame are clearly winners.

Retail “active” traders that favor market orders could be buying or selling at a slightly disadvantaged price. Also they could be fooled by a false sense of momentum.

Retail investors that are dependent upon gradual investment sales for living expenses are most vulnerable. It can also be said the retail mutual fund shareholders will suffer slightly lower returns. But, investors in low churn funders should not be concerned.

If regulators rein in on this form of front running and insure firms have the capital to cover their risk, I see little harm in high-frequency trading. In many ways high-frequency trading has the same risks and benefits as programmed trading on the news.

Disclosures: none

Comments

[wendling_r:]

Good article. I agree that with the proper checks and balances everyone who wishes to participate in this form of trading can have equal chances of profiting.

As for disclosure, I do currently own NYX and have just written a report on where I see it moving in the coming months. For those interested click on my site attached with this note and click on the reports tab. It will take you to the report.

Richard W. Wendling

Aug 02 09:00 AM

[Alan Young:]

As it is working now, HFT skims about 20-30 bps from the spreads, enriching GS at the expense of retail and institutional investors.

Now, suppose there were a tax of, say, 10-15 bps on all securities transactions. HFT immediately becomes unprofitable, and disappears. Low-frequency transactions will be slightly more profitable, so investors benefit. AND, the government would make a few billion$ to reduce debt, or to fund investor-protection activities.

Aug 03 12:03 AM

[SivBum:]

Schumer had made his case to Shapiro who is still asleep from her Bush II years.

Aug 03 01:00 PM