More Institutional Investors Are Speaking Up About HFT
At the end of our 2012 book “Broken Markets” we wrote:
“You may be thinking that the insiders have the game rigged and your voice will never be heard. Not so. The lesson we learned is that every voice in the market is important and needs to be heard. Enough is enough. Make your voice heard. It’s time to repair our broken markets.”
When we wrote those words, we were feeling kind of lonely in the market structure debate. Although we spoke to many institutional and retail investors that shared our frustrations, the debate was still being dominated by the HFT enablers. Well, it’s been almost two years since we wrote those words and we are not lonely anymore. There has been a chorus of institutional and retail voices that have spoken up more forcefully.
We would like to highlight one of those voices today: Lord Abbett.
Lord Abbett has just published an excellent note titled “High-Frequency Trading: The Tricks of the Trade” which identifies key issues in the high frequency trading debate and recommends some defensive measures that could be taken today to mitigate some of the damaging effects of HFT.
As stock pickers who do their own homework, Lord Abbett is frustrated that HFT is siphoning off some of their hard earned alpha. In their note, they identify three types of HFT:
1) Rebate Arbitrage:
“One HFT technique that can influence market prices involves the relatively small rebates offered by equity exchanges in order to generate trading flow and, consequently, revenue. Once an HFT program identifies the footprint of an existing order, it can trade ahead of that order—thus potentially affecting the price of the stock—while also collecting a rebate.”
Note that Lord Abbett properly identifies the rebate trader as trading ahead of the original order. Technically, this is not “front running” since the rebate HFT is a prop trader that does not have any clients.
2) Market Making:
“This process may start with an HFT program identifying an existing order and how much price discretion the order has to buy or sell a stock. Price discretion could be determined, for example, by the existing order’s response to a series of offers to sell stock from a high-frequency trader. Once this discretionary amount is identified, the HFT program could trade ahead of the existing order and then fill that order at its price threshold. As a result of this process, the market maker would provide the investor with liquidity, but at a potential cost of moving from its initial price toward its discretionary threshold.”
So called benign market making HFT is called into question here by Lord Abbett. They rightly question the cost of the “liquidity” that the market makers are supplying.
3) Predatory Trading:
“Once an HFT program identifies an order, it might adjust its quotes for the stock, therefore prompting the investor to adjust as well. For example, if this process results in an investor raising its bidding price for a stock, the HFT program might sell the stock short to the investor at that price. Yet, considering that the sequential bidding process inflated the price of the stock, the HFT program could cover its short position once the stock price presumably reverts to tis previous level. ”
Lord Abbett seizes here on the most nefarious HFT practice. While we know that trading is predatory by nature, it is how HFT is identifying the orders that we question.
While Lord Abbett waits for regulators to do their jobs and clean up the market, they are not just idly sitting by and watching their orders get compromised. In their note they say: “The first step a firm can take to protect its trades against HFT’s influence involves avoiding the trading patterns that these programs might identify.”
They go on to recommend:
– trading with pure liquidity venues
– cover your tracks by carefully selecting how you submit orders
– Be unpredictable
– Constant human oversight of algorithms
We’re glad to see firms like Lord Abbett speaking up more now. We’d like to think that our constant focus on the issue and call to action has inspired some folks. We do know that the only way regulators will act is if the owners of the market (all of us) keep expressing their concerns.