Life in the City: Closing down the fast lane
High-frequency traders are already under attack from US regulators. Now City minister Lord Myners wants a similar sort of crackdown in this country. Stephen Foley explains why the technique is so controversial
Wednesday 04 November 2009
It's controversial. It's on its way across the Atlantic. And the British Treasury minister Lord Myners doesn't like it. "It" is high-frequency trading, a catch-all term for the kinds of computer-generated trading that has driven a huge spike in the numbers of shares traded on the New York Stock Exchange and other trading platforms in the US. Lord Myners says that companies risk becoming the "playthings" of speculators.
His is a complaint that is hardly new. Corporate bosses have grumbled since time immemorial about here-today-gone-tomorrow shareholders, who are less interested in supporting their business for the long term than they are in reaping a short-term profit.
The difference is that the short term is shorter than ever, thanks to the rise of the machines in share trading. An industrial boss of old might be furious that his shareholders cannot see beyond their quarterly performance assessment; today's executive might find herself with shareholders whose interest in her company lasts a few minutes, seconds, or even milliseconds.
Inevitably, hedge funds and the proprietary trading desks of the big investment banks are behind the trend. In recent years they have lavished big bonuses on computer geeks who can write sophisticated algorithms for buying and selling shares in tiny quantities, often for just seconds at a time, in the expectation of harvesting millions of small profits. The exchanges, and the creators of rival trading platforms known as "dark pools", have been enthusiastic cheerleaders, since the more trading there is, the more commission they make.
The trend went exponential in 2006 when the NYSE introduced electronic trading. By 2008, the average volume of shares traded in the US every day had doubled, and the number of individual orders was up by 150 per cent. Now, an estimated 60 per cent of daily share trading volume is accounted for by high-frequency traders using computer algorithms.
It is a trend that Lord Myners, a former fund manager and the Financial Services secretary since October last year, says he doesn't want to see develop in the UK. He told the BBC that it was turning the capital markets, in effect, into giant casinos.
"It has gone too far, it has now lost its supporting function for the provision of capital to business and has become a game to be played," he said. "The fact that people can own shares for nanoseconds seems completely divorced from the concept of a joint stock company and distributed share ownership. The danger is that companies become the playthings of speculators."
Regulators over the pond are already on the case, albeit after the fact and under political pressure. The Securities and Exchange Commission (SEC) has been conducting a wide review of the structure of the markets, taking in the development of dark pools and other computer-driven trading practices, but it is also zeroing in on high-frequency trading.
Speaking to a securities industry conference last week, the SEC chairman, Mary Schapiro, said the organisation was collecting data for a discussion paper in the New Year and possible new regulations later in 2010.
"I believe we need a deeper understanding of the strategies and activities of high-frequency traders and the potential impact on our markets and investors of so many transactions occurring so quickly," she said. "And we need to consider whether there are additional legislative authorities needed to address new types of market professionals whose activities may not be sufficiently regulated."
For high-frequency traders, every millisecond counts. Even the time it takes for data to travel across the internet can be critical, so there is a race to get one's computers as close to the exchange as possible. Some – though by no means all – of the high-frequency trading strategies involve putting in a buy or sell order not with the intention of filling it but simply to get information about the likely direction of a share price, information that can then be used for deciding on real trades.
In the relentless drive for a competitive edge, some practices are already causing concern to the SEC, whose responsibility is to level the playing field.
Flash orders, where favoured clients are shown buy and sell orders from an exchange milliseconds before everyone else, already look set to be banned. Now the SEC is considering restrictions on the practice of "sponsored access", where some high-frequency traders are allowed to plug themselves directly into the exchanges' trading computers, instead of having to go through a regulated broker-dealer, which would slow them down. That's "like giving your car keys to a friend who doesn't have a licence and letting him drive unaccompanied," Ms Schapiro says.
Market players in the US are confident that the SEC's concerns are with specific practices, rather than with the whole phenomenon of high-frequency trading, which Ms Schapiro called a "vaguely-defined category"). A common refrain is that regulators shouldn't try to throw the baby out with the bathwater.
Duncan Niederauer, the head of the New York Stock Exchange, was blasé about the prospect of a clampdown last week when analysts questioned him after the company's financial results. "Our guess is they might ask for some reporting around it or something like that, but I don't think we're going to see any major initiatives that are going to stifle high- frequency market making," he said.
Note the phrase: high-frequency market making. In that one phrase is the case for the defence. In the dim and distant past – that is, 2006 – all share trades on the New York Stock Exchange had to go through a human market maker, whose responsibility it was to make sure that buyers could always find a seller, and vice versa. Electronic trading has largely cut out these middlemen, but Mr Niederauer and others argue that the high-frequency traders now fulfill the market makers' role. They trade so often and across so many stocks, that they are always available to buy from, or sell to, a longer-term investor. The easier it is to find a counterparty to your desired trade, the less you'll have to pay to get the trade done.
Goldman Sachs, in a discussion paper on its website, says: "The US equities market is increasingly efficient and is broadly regarded as the best in the world. Spreads are reduced, execution costs are down, and liquidity is up. The investing community, especially the retail investor, has benefited from the evolving market structure and industry competition.... 'High frequency' strategies have to a large degree replaced the traditional roles of specialist and market maker in providing liquidity to the marketplace."
Giles Nelson, who founded Progress Apama, which makes high-frequency trading software, said Lord Myners' criticisms missed the point. "You'd be forgiven for thinking that HFT only came in existence in the last 12 months. The practice has been around for over 10 years now and in the main been used to create more markets, produce more market volume, and enabled more liquidity than ever before. And while there are instances where traders have bent (or even broken) the rules, a blanket ban on the use of the technology is both impractical and unnecessary."
In other words, there is a baby in the bathwater somewhere.
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