09.13.2011
By Terry Flanagan

Market Participants Wary of HFT

A new study shows that a majority of institutional investors are concerned about the effects that high-frequency trading has on the marketplace.

High-frequency trading is often criticized for a variety of reasons, including its manipulative and predatory nature. Reports have often had conflicting results, with some finding that such trading doesn’t have a significant impact on the marketplace, while others find that it creates unnecessary volatility swings. A study performed by alternative trading system operator Liquidnet shows that a significant majority of asset managers are concerned about the impact of HFT on the equities market.

“The number one concern around high-frequency trading was about transaction costs and leakage,” said Seth Merrin, chief executive officer and founder of Liquidnet. “In the volatility of the last few weeks, you can see its impact. The catalyst was massive outflows from institutionally managed funds, which put a lot of pressure on the market. This creates signals for high-frequency traders. That is what caused the doubling of trading volume in the market, and that’s what caused two to three percent swings on a daily basis. Clearly there was no fundamental change in the macro environment that said the market was worth two percent less today and three percent more tomorrow.”

Liquidnet’s survey polled traders from about 630 institution asset management firms collectively managing more than $13 trillion in assets. The study showed that more than two-thirds of those surveyed in North America were concerned about the effects of HFT, while nearly 60 percent of European respondents and more than half of those in the Asia-Pacific region felt it was a problem. Industry observers estimate that HFT makes up as much as 75 percent of overall equities trading volume in the U.S.

“The largest form of HFT today is the momentum type of arbitrage,” Merrin said. “It simply looks for catalysts where there is a supply and demand imbalance in the marketplace. That is the kind of trading that leads to a ‘flash crash’ and the massive volatility in August. That’s bad for the entire market. In the past, markets went up and down for fundamental-based reasons. Today, it is completely fundamentally agnostic. That’s bad for the markets.”

Despite the problems posed by HFT, the fact is that it’s become a substantial segment of the marketplace and is here to stay.

“This is a new reality that has to be dealt with all over the world,” Merrin said. “It’s incumbent on (institutional traders) to protect the investors’ money and position. Now that we have an institutional marketplace, they should only trade there.” Merrin likens the trading landscape to other industries, such as consumer goods, which separate wholesale transactions from retail. “It’s no different from how every other industry is set up. In this world, likewise, it’s absurd to think that an institution with a 200,000 share order should go to a store that only has 300 shares for sale. It’s up to institutions to separate themselves and remove triggers and catalysts (for high-frequency traders) from the retail market.”

Liquidnet and other dark liquidity pools are marketplaces where institutions and asset managers can execute large block trades anonymously and without market impact.

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