The recent publication of Michael Lewis’ book, Flash Boys, has reinvigorated the debate about the practice of High Frequency Trading (HFT) and the potential to exploit and profit from the inefficiencies in today’s market structure. In order to stop this activity regulators and lawmakers will have to act. With the recent $4.5 million fine to the New York Stock Exchange by the SEC and open investigations by multiple government agencies into HFT, reform of some kind is likely imminent. In the meantime, Redwood Investments is committed to minimizing the impact of predatory trading tactics on our orders and continuing to seek best executions for our clients.
What is High Frequency Trading?
HFT broadly comprises a group of investment strategies that utilize technical speed advantages in combination with highly sophisticated algorithmic computer programs to rapidly enter and exit positions. While not necessarily news to market participants, Lewis’ message that “the market is rigged” has brought these strategies, and questions about their fairness, to the forefront of public debate. Proponents of HFT argue that they are the new market makers and that they have helped to create a more liquid and efficient market. Their speed and tremendous liquidity lead to narrow spreads and cheaper commissions; benefits enjoyed by all investors and market participants. As Lewis and others have brought to light, however, HFT can also be predatory and create unfair advantages at the expense of other slower, less technologically savvy investors.
Examples of Predatory Issues and Practices
Pinging. A tactic that attempts to identify large orders. HFT firms enter small market orders of 100 shares or less in most publicly listed stocks. With minimum risk and cost, this allows for HFT algorithms to calculate the likelihood of where a large order might be in the market. Once confident that an order is out there, they commence various strategies to profit off of the found order.
Latency Arbitrage. With co-location services being sold by the public exchanges, HFT servers have access to direct pricing feeds that are faster and more accurate than the Security Information Processor (SIP), which is responsible for updating the national best bid and offer (NBBO) to the public. This speed advantage allows risk-free arbitrage between pricing sources.
Electronic Front Running. While not risk-free, this “risk-arbitrage” strategy consists of identifying an order filled at one exchange and then beating the market to the rest of the exchanges to “front-run” the rest of the order. Effectively, this strategy moves the market away from the investor and deteriorates the execution price for the investor (increases the price when buying or decreases it when selling). This strategy can trigger momentum in the security and significantly affect the traditional investor’s execution price.
Rebate Arbitrage. A strategy that seeks to claim the rebates offered by exchanges for passively providing liquidity (limit orders). The rebate is designed to incentivize market participates to provide liquidity. The issue is that the liquidity offered is not real - most orders are canceled. As a result of the high order cancelation rate, the volume that appears to exist in the market for a security is often wildly overstated. This vanishing liquidity exacerbates volatility in the market, leading to rapidly widening spreads and dramatic price changes (i.e. flash crashes).
What is Redwood Doing to Protect Against High Frequency Trading?
While the current market structure prevents Redwood from completely immunizing against predatory HFT, we have taken a number of steps to minimize the impact to our clients.
Eliminated trading with brokers executing in dark pools or at Alternative Trading Systems (ATS) that only use the SIP for pricing. This limits the speed advantage that HFT’s rely on for Latency Arbitrage.
Utilizing simultaneous routing algorithms wherever possible to access liquidity across all exchanges and dark pools at the same time. This limits the effectiveness of Electronic Front-Running strategies.
Utilizing minimum fill sizes (100+ share lots) to combat pinging and raise the cost to the HFT of identifying our order.
Only trading with brokers that are members of the new IEX pool (mentioned in Flash Boys) and are agnostic or exchange neutral. The result is that exchange rebates will not influence where executions occur.
Requesting that sell side brokers provide Redwood with detailed execution reports that contain information on how our orders are handled (location of executions, algorithms used, principal vs. agent, etc.). This information provides much needed insight and transparency into our executions.
Meeting with brokerage firms with whom we trade to confirm that their trading processes meet Redwood’s requirements.
Employing more crossing products.
The HFT situation will continue to be fluid as regulatory and market structures evolve. New regulatory investigations and responses by market participants appear to be occurring daily. Redwood is actively monitoring any changes and will adjust trading strategies to capitalize on opportunities that protect clients and drive best execution.