10.23.2012
By Terry Flanagan

Mixed Blessings for Buy Side as Algo Rules Descend

With an increasing number of computers battling it out to execute trades on exchanges far quicker than the blink of an eye, in a bid to elicit minute profits on each trade, institutional buy-side investors are finding it ever more difficult to navigate markets dominated by high-frequency traders.

It is thought that HFT now accounts for over 60% of all U.S. daily equity volumes, with that figure around 40% in Europe, as these high-speed traders look to move in and out of positions tens of thousands of times a day to compete for very small but consistent profits.

However, the purpose of financial markets has not traditionally been to provide a forum for this split-second trading. Buy-side institutional investors, who generally trade in big blocks of shares and want to invest in the long term, have become disillusioned by not being able to properly execute their orders on the lit exchanges and instead see their orders instantly picked off by the algorithms of HFT firms.

“It is worth going back to the days before electronic markets around 10-15 years ago and they were incredibly inefficient,” Jason Rolf, a fund manager at Amati Global Investors, an investment manager, told Markets Media’s recent European Trading Investing Summit in London.

“So electronic markets and some forms of HFT have been beneficial, for sure. Five years ago, the markets worked very well and pricing was very efficient. Since then, it’s gone very bad with HFT shown to increase volatility and liquidity in a lot of markets has dropped off enormously.”

Buy-side institutional investors are becoming more and more concerned that order book liquidity is illusionary due to the presence of HFT. They say that some HFT algorithms send out false quotes that try to trick the market into moving in one direction or the other and that algos can also jam exchanges with thousands of orders.

“The prices that wobble when you look at a screen—that’s what you see in a few hundredths of a second,” said Rolf. “But these people trade in a millionth of a second so what’s behind that is a whole lot more and I don’t think people realize how fast it actually is.

“Sometimes, when we put an order into a market now, you can see immediately a lot of the rest of the market reacting to it which is just from machines really. And when you pull that order back out of the market, immediately that changes. So it is almost all machines out there driving the business.”

In the Dark
This has seen many institutional investors head to ‘dark pools’ where bid and offer prices remain hidden out of sight. And while the order books are filled with competing algos and the drive to ever lower latency, it appears that it will be some time yet before institutional traders re-appear en masse to the lit venues.

“Regulators need to cap trading speeds,” said Rolf. “A thousandth of a second—I don’t see what benefit is added by trading quicker than that.”

Regulators, though, on both sides of the Atlantic have woken up to the dangers of HFT, after several well-publicized market blow-ups, such as the ‘flash crash’ in 2010 and this year’s Knight Capital debacle and the botched IPOs of Facebook and Bats Global Markets.
The European Securities and Markets Authority (Esma), the pan-European regulator, has been quickest off the mark and has already introduced detailed guidelines, which have been in place since May, to better monitor algorithmic trading practices such as high-frequency trading.

Although a new report commissioned by the U.K. government called the Foresight Project has said that some of the proposals in MiFID II to limit the more predatory behavior of high-frequency trading, such as minimum resting times of 500 milliseconds, may actually damage overall liquidity and is calling on the European Union to rethink some of its plans. Policymakers in Brussels are keen to limit HFT and countries such as Germany have also already begun to push ahead with plans to curtail the practice.

Many institutional investors want to see the excesses of HFT curbed in some way but are worried that some of the policies being suggested at EU level, such as the 500 millisecond ruling, may actually be counter-productive to the market as a whole and will damage genuine liquidity in the long run and force up execution costs.

The report also touched on the issues facing the buy side in today’s high-speed trading environment. “The bulk of the evidence suggests that, in normal circumstances, HFT enhances the quality of the operation of markets, though the returns to HFT may come in some significant part from buy-side investors, who are concerned that HFT may have the effect of moving prices against them,” said the report.

The U.S. Securities and Exchange Commission, meanwhile, recently held an industry roundtable to address fears over the rise of HFT and the two key takeaways to come from the event were the implementation of a so-called ‘kill switch’ to allow a market participant to shut down trading, and a best-practices guide to electronic trading. However, there is nothing yet set in stone for U.S. markets in terms of regulation.

U.S. Lagging
The possible attack on liquidity, seen by many U.S. market participants as the key to providing well-functioning markets, if regulations were to be put in place to better monitor HFT is one of the reasons why the U.S. is slightly lagging Europe at present on the matter. Proponents of HFT argue that their form of trading brings much-needed liquidity to the market place.

Regulators in Europe, too, though, are concerned about the rise in these little regulated dark pools and want to see more trading done in a transparent way on more regulated exchanges, which have become the playground of the HFT firms. But this could just see buy-side institutional investors forced back on to the very venues that they have fled from.

“If you speak to most buy-side traders, they are not going to make an assessment of where to put up a block or where to take a value of the stock just on where the bid and offer is, they are going to look where it is traded,” Owain Self, global co-head of direct execution and global head of algorithmic trading at UBS, a Swiss investment bank, told the Markets Media conference.

“The buy side don’t like the order book so are looking at other ways of trading blocks or trading away from the screen. But the regulation is pushing in the exact opposite way in that they don’t want trading away from the order books. Regulators want trading done on a transparent place and are trying to push all the flow on to there.

“We are not allowing for this evolution of facilities, whether they be over the phone or more systematic, and for the brokers to allow for a more attractive place for clients to trade with other clients. Clients want one thing and regulations are pushing in the other direction. I think that is unclear at the moment. What is the intention of pushing everything to the order book where the investors in the community are looking for different choices in the market place?”

Christopher Gregory, co-founder and chief executive, Squawker

Christopher Gregory, co-founder and chief executive, Squawker

Christopher Gregory, co-founder and chief executive of Squawker, a London-based trading platform that is set to go live early next year allowing sell-side firms to execute block trades anonymously using social-networking technology, concurred: “The drive in the regulation for transparency, standardization and a pan-European nature has overlooked some quite important things—liquidity in block trading.

“It has become harder if anything to do a block trade. The prices, when you look at the price on the order book, it is almost is a phantom price. It just wobbles in front of you and disappears if you reach out and try to grab it as it moves so fast. I don’t think you will find many traders who like the markets at the moment, trust them or understand the way order books are going.”

Most buy-side firms also use sophisticated algorithms nowadays to execute their trading decisions, albeit in different ways to HFT firms, and the buy side are being warned that the Esma automated trading rules are not just targeted at HFT firms.

“Let’s not blame all of this on HFT,” said Self at UBS. “The FSA [Financial Services Authority, the U.K. regulator] case, the biggest one they have brought for layering and spoofing so far, was brought about against a group of individuals, not HFT—a group of day traders sitting in a room. So market abuse should be for everyone, any participant in the market. We shouldn’t assume everything is done by HFT.”

Cost of Compliance
And the cost of complying with all of these new guidelines is also likely to be a problem for buy-side firms, some of whom still use legacy compliance systems.

“Many buy-side firms are still just paying lip service to controls around market monitoring at present,” Monique Melis, member, regulation and risk at KineticPartners, a consultancy firm, told the Markets Media conference.

“This is something the regulators will focus on going forward especially with initiatives from Europe. Firms rightly say it is complicated and costly to install market monitoring systems and controls—despite that a lot of firms are still doing it by hand through Excel spreadsheets or a junior person looking at a Bloomberg terminal by trying to pick up what the traders or the algorithms or the high-frequency is doing.

“[Esma] has said many times that they are going to look into the conduct of firms. What we will see is the regulator taking action higher up in firms when things go wrong. So it won’t be sufficient to say my algo played up or my system played up. They will want to get to the bottom of this. That will require that IT and front office becomes more literate in financial regulation and risks.”

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