Last year, our friend RT Leuchtkafer wrote a letter to the Financial Times where he coined the phrase the “high frequency four horsemen”. We would like to update this four horsemen of high frequency trading phrase with some more specific HFT advantages. The four horsemen of high frequency trading that we refer to are: data feeds, colocation, order types and rebates. We have written extensively about how a combination of all four of these horsemen gives the HFT a unique advantage in the equity market. Taken by themselves, each horseman does not give that much of an advantage to the HFT. But combining all four gives these hyper active traders just enough of an advantage so they can guarantee success almost every day.
One common feature of these horsemen is that they are all supplied by the stock exchanges (or should we say the “data” exchanges). Today, we would like to once again focus on rebates.
The HFT game is getting more and more competitive as the arms race has entered overdrive. HFT’s are finding it difficult to make money since there is less and less natural order flow in the market that they can scalp. Their margins have no doubt been impacted as they find less and less “arbitrage” opportunities. As in any business, when margins compress, cost cuts soon follow. In the HFT world, this means squeezing their suppliers for cheaper rates.
While exchanges offer their high frequency trading clients a better rebate for “adding” liquidity than most of their other clients, rates for taking liquidity are not discounted as much. Currently, NASDAQ has a standard take rate of $0.0030/share. Aggressive takers of liquidity most likely will look for cheaper alternatives than NASDAQ when routing including dark pools and inverted fee exchanges. These high volume aggressive takers are no doubt focused on the most active stocks and probably play the “zero plus” game that Haim Bodek has documented. Exchanges want their business.
NASDAQ has concocted a new pricing scheme (which by the way has been deemed non controversial and does not need SEC approval) to attract these high volume takers. They are offering the discounted take rate of $0.0028/share in only “designated securities” to a firm that “accesses, provides, or routes shares of liquidity that represent more than 0.25% of Consolidated Volume during the month, including a daily average volume of at least 2 million shares of liquidity provided.” These 18 designated securities include the most active names such as BAC, XLF, INTC, EEM and YHOO. When trying to rationalize this new discount to the SEC, NASDAQ stated: “Incentives focused on the members that provide liquidity are prevalent in securities markets because higher levels of liquidity provision aid price discovery and dampen volatility.” How is discounting a take rate providing an incentive to add liquidity? Clearly, this is just another way to tilt the playing field in favor of the HFT.
Once again, the for-profit exchanges are catering to their high frequency clients at the expense of their other members. The four horsemen of high frequency trading are getting old and tired. It appears that the HFT game has been maturing while the flaws in the business models of the exchanges have been exposed.