This is a guest post on trading from Tusk Trader (check out the newly launched site: www.TuskFund.com), an experienced Bay Street trader who will be writing here until Tusk’s own blog is set up. Tusk had a front row seat to the twists, turns, and almost collapse of our capital market systems a few years ago and provides a unique perspective you won’t find anywhere else. For most people, financial literacy is the elephant in the room. Let Tusk Trader help change that. If you are on twitter, make sure to follow Tusk at @TuskTrader
High Frequency Trading. A very large topic, with more nuances, sub-topics and Street opinions than a conversation about Tebow. High Frequency Trading is a contentious issue with many variables that cannot completely be viewed in isolation. I hope this is just the start of a longer conversation about a complicated trading issue.
First, I want to get everyone up to speed on what High Frequency Trading (HFT) is. HFT computer programs generate buy and sell orders at lightening speed as the HFT program reacts to market data that is constantly changing. These orders are inputted at such a rapid speed that trades generated by a human have zero chance of competing (getting the fill first) and the average computer generated orders (a non HFT one) will also get left in the dust. The timing is calculated down to the millisecond. HFT trading occurs in equities, commodities, ETF’s and almost all things traded electronically. These orders can be generated from things like movements in an order book, or produced while following and tracking information from another market or indices that a particular stock is connected to.
Not all computer trading programs are HFT. And not all HFT programs are predatory. The issues surrounding HFT usually stems from the fact that it only takes one predatory HFT program on a stock to dramatically affect how the trading is occurring on that particular stock. On an average day on a trading floor, 80% of swearing by a trader is now directed at this type of program that he or she encounters in their day.
There is one specific type of HFT program I would like to shed some light on and to pose some questions about; The HFT programs that are only about providing liquidity to collect credits. These programs (and there are frankly a lot of them out there) have a singular goal to accumulate credits. When you trade passively on many electronic exchanges, you get a credit and when you trade aggressively, you pay a fee. (These fees and credits are separate from any charges accumulated by the at home investor trading through a platform). The HFT programs are designed to follow and react to orders in the order book on a stock so that the program is able to step in first and be filled passively. This forces others to trade aggressively when they otherwise would have been able to trade passively. These fees and credits have been around for a long time at varying amounts. I am, as a trader, okay with the idea of being rewarded for being passive. When placing an order in passively you are providing liquidity to someone else. Receiving credits makes sense when there is a decision a market participant has to make about placing an order that has a bigger purpose than just getting a credit.
The questions I pose, however, are:
- Where is this money for the credits coming from?
- Who is the ultimate payee of these credits and are these market participants receiving the benefit of paying that fee which is ending up as profit to the HFT firms?
- What fees are being charged to other market participants so that High Frequency Trading programs can trade to solely collect credits and not actual trading profits?
Many of these programs are predatory to the extent that they are out right manipulating the market. That needs to stop. I wonder how much market liquidity would be lost if aggressive fees were lowered to a fraction of what they are now and passive credits were zero. Would the markets function and have better flow if the goal of every trade was to actually get filled at the price, not to receive a credit for doing so?
HFT programs need to dominate a lot of the activity to collect the credits and be profitable. It is not an exaggeration to say that 30% or more of all traded volume currently comes from some type of HFT program. At any given time, up to 70% of orders in a trading book are generated from HFT programs like this. How much volume would the markets be left with if these programs disappeared? Is forcing everyone else to pay fees so that there is a big enough pool to collect credits from reasonable? How much liquidity is being provided? Do these HFT programs scare off real volume that could be in the market at a lower fee for all?
I am sure some of you are frustrated by the number of questions and lack of answers, but that is a reflection of the current market reaction to HFT’ing. Most of these questions have no definitive answer. It will take regulatory and exchange related changes for the answers to become clear.
My chief concern is that the people paying the aggressive fees are not getting any benefit. The people funding the credits should be the ultimate benefactors of it, and I don’t think they are with HFT’ing in its current form.
*To trade passively is to place your order in the order book, outside of where it is currently trading, and to wait to be filled. To trade aggressively is to hit or take out orders in the order book and hence, be filled immediately.