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April 22, 2010 11:59 am
High-frequency traders engage in “opportunistic and fleeting” trading that may make markets more volatile and are of little benefit to ordinary investors, according to one of the largest online brokers in the US.
TD Ameritrade said the “significant and rapid increase” in high-frequency trading volume in US equity markets affected retail investors “in many ways, the majority of which are not to their benefit”.
Its comments, in a letter to the US Securities and Exchange Commission, are likely to reignite controversy over the recent rise of high-frequency trading in US equity and derivative markets.
They are also the first sign – since debate over the role of high-frequency trading began last year – of a backlash from brokers that handle millions of share orders from average smaller investors.
Yet the comments will be refuted by many in the markets who believe that high-frequency trading adds liquidity to the markets, especially in times of crisis when traditional investors flee.
High-frequency trading, or HFT, refers to a variety of trading strategies that use ultra-fast systems and sophisticated computer program to generate, send and carry out orders all in a split-second.
TD Ameritrade said that while high-frequency traders “may add needed liquidity into the markets, unlike specialists and OTC [over-the-counter] market makers who are required to maintain two-sided markets, HFT liquidity is far more opportunistic and fleeting and under no such two-sided requirement”.
The broker added: “In fact, the speed at which HFT trading volumes fluctuate may add to volatility to overall liquidity in the markets.”
TD Ameritrade’s letter came in response to requests for public comment by the SEC as part of a sweeping review of US equity market structures, partly prompted by the inroads HFT has made into US markets. Tabb Group, a consultancy, says more than half of US equity markets are made up of some sort of HFT.
The SEC has said it wants to know whether these and other technological advances give traders an unfair advantage over longer-term investors. In an initial report in January, on which it asked for comment, the SEC said: “Does the fact that professional traders will likely always be able to trade faster than long-term investors render the quality of these markets unfair for these investors?”
TD Ameritrade responded: “The current market structure has created incentives for proprietary trading firms to use high volume computer algorithms, pinging, co-location and other approaches to take advantage of retail order flow.”
It said the “rapid order placement and high cancellation rates” used by high-frequency traders had “only exacerbated flickering quotations, which undermine retail investor confidence in the execution quality they obtain”.
TD Ameritrade said: “Simply put, retail investors expect the best price they see and they do not accept the excuse that the quote they saw is not attainable.”
The SEC, it added, should “strongly consider” the impact that excessive order cancellations have on the markets, market data and costs for retail investors.
The broker backed up its claims by saying it had experimented with using high-frequency traders to carry out a “small portion of its client order flow”.
“The result was inconsistent execution quality, partial mixed lot fills and no size enhancement,” TD Ameritrade said.
High-frequency trading was “opportunistic liquidity, which generally does not serve the individual investor well”.
The broker called on the SEC to implement a surveillance system to root out potential manipulation and market abuse. “There is the perception in the marketplace that HFTs are trading at the expense of retail investors, and this perception can only be countered by a dedicated surveillance effort.”
However, defenders of rapid trading, such as large market-making firms Getco of Chicago and Optiver of the Netherlands, argue that the term high-frequency trading encompasses many types of trading that are being unfairly swept up in the controversy.
The SEC has acknowledged that high-frequency trading is “not yet clearly defined”.
Craig Donohue, chief executive, said CME believed HFT was “an important part of daily trading activity in the marketplace and it has developed in response to technological and trading strategy advances”.
“There is evidence that HFT increases liquidity and transparency in the marketplace and narrows spreads, which allows investors to buy and sell securities at better prices and at lower costs,” Mr Donohue said.
He added that the use of HFT by proprietary trading firms, investment banks, hedge funds and index traders had made the market “more efficient and competitive for all market participants”.
The rise of HFT and of technology that allows trading in microseconds poses a dilemma for regulators, who must decide whether it is feasible to impose rules on certain market participants who happen to be able to afford highly sophisticated trading technology that – some say – gives them an unfair advantage over those who can not.
Mr Donohue warned that “any attempt to place significant restrictions or limitations on HFT would be harmful to the marketplace and result in less efficient and less liquid markets”.
He said: “Efforts to place limits or impose regulatory burdens on HFT in the US may encourage HFT users to shift the trading they currently conduct in the US to Europe and other foreign jurisdictions that are already well-equipped to handle additional growth in both equities and futures.”
The study comes at a time of unprecedented change in the way markets function, with increasing amounts of share trading taking place away from formal exchanges, involving what TD Ameritrade called “an explosion of growth in market centres, exchanges and proprietary trading firms”.
The SEC study is also looking at the rise of “dark pools” – facilities that allow the anonymous matching of buy and sell orders – and the practice of traders placing their computer trading systems physically in data centres to be near exchanges’ matching engines.
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