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March 15, 2013 5:40 pm

Men or machines: who runs the markets?

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Server cables at the FT's data centre in West Londo©Charlie Bibby

It has never been cheaper or faster to trade shares. But the same technology that has reduced costs for private investors is also being accused of increasing market volatility and enabling trading firms to profit at the expense of individuals.

High speed, automated trading, also known as high-frequency or algorithmic trading, is a way of buying and selling at superhuman speeds using computer programs.

Firms use sophisticated software to trade shares in a matter of microseconds – one-millionth of a second. In the time it took you to read the first few lines of this article, a high-frequency trader could have executed millions of orders.

Some programs analyse news stories while others simply react to movements in prices, holding a high volume of shares for a very short space of time and earning a profit on thousands of tiny price differences.

Analysts believe that these transactions now account for about half of all trades made on US equity markets and approximately a third in Europe, meaning that humans are increasingly absent from buy/sell transactions.

Firms such as Getco say they are making markets more transparent: narrowing spreads, removing the commissions that drove up costs and creating more liquidity, which means retail investors can buy and sell shares more easily.

But some analysts believe that the advantage HFTs gain in speed and access to the market do not benefit “real” investors.

A report by the economist Andrei Kirilenko, professor at the MIT Sloan School of Management and former chief economist for the Commodity Futures Trading Commission, published at the end of 2012, concluded that high-frequency traders take profits at the expense of retail investors.

Reponsibility lies with brokers

Philip Stafford

For non-participants, dealing with high-frequency trading can appear to be like using a bicycle on a Formula One track, writes Philip Stafford.

Traders using specialised computers and private telecommunications networks to execute deals in milliseconds seem a world away from a investor simply using a home computer or even dialling up a broker.

What chance do they have of beating the machine? The answer is not a lot. But that doesn’t necessarily mean an investor will end up as roadkill.

High-speed electronic market makers frequently make the case that their business makes markets more efficient by lowering the spreads on prices, benefiting the end investor. But the problem is that computers and their networks leave trails that can be exploited. Big brokers are increasingly monitoring ways to avoid having their orders chopped up by the high-speed machines.

Responsibility for spotting and reporting market abuse by customers falls on their shoulders. And investors should not be slow to grill their brokers hard on exactly how the latter are achieving “best execution”.

Philip Stafford is Editor of FT Trading Room

Kirilenko examined trading in S&P 500 e-mini futures (contracts based on the future value of the Standard & Poor’s 500 index) between August 2010 and August 2012 and found that the small retail investor lost $3.49 on average for every contract they traded with an aggressive high-frequency trader.

Another worrying study published in 2010 by Yale School of Management found that HFT was directly linked to stock market volatility. The report was published soon after a short, but dramatic, fall in US equity prices, dubbed the “flash crash”, which highlighted the pitfalls of computerised trading.

In the same year Martin Wheatley, who now heads the UK’s new consumer financial regulator, the Financial Conduct Authority, wrote in the Financial Times explaining why he was worried about the industry’s impact on markets. “HFT has the potential to bring risks and fragility,” he said. “When a market dislocation arises, HFT firms react ahead of other participants and this can create a nerve-racking situation.”

However, Remco Lenterman, chairman of the FIA European Principal Traders Association, says he is puzzled by the idea that retail investors are at a disadvantage because of HFTs.

“The UK Foresight report [a study commissioned by the British government, published in 2012] concluded that there was no link between HFTs and volatility,” he said. “HFT firms provide liquidity, and have made the markets cheaper. If someone is a day trader, trying to compete with professional traders, then it may have got tougher to make the same returns. But the end users – the investors – are benefiting from reduced intermediation.”

HFTs may have the advantage of fast access to the market, but for long- term investors this shouldn’t matter, argues Dave Cliff, director of the UK Large-Scale Complex IT Systems Initiative at Bristol University.

“One of most successful investors in history is Warren Buffett and his strategy is to identify companies where there is growth and hold shares for years. The thinking that goes into that decision is something a computer is bad at,” he explains.

“There is a famous example where shares in rubber companies did well when Aids became a major public health issue. This sort of lateral thinking is something computers don’t do well. Fundamental, long-only investment is still the domain of human experts.”

After years of rapid expansion there are indications that the growth of high-frequency trading may be slowing. As investors pulled money out of the stock market and equity trading levels fell, opportunities for fast traders declined. Profits from HFT in US equities are estimated at $1.25bn last year, down by more than a third from 2011, according to Rosenblatt Securities, the brokerage firm.

But the industry has some new ideas up its sleeve and is now stepping up its presence in other markets. According to Aite Group, the financial services consultancy, HFT’s share of foreign exchange trading is now 40 per cent, up from just a quarter in three years.

 
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Regardless of the spread of HFT and automated trading, humans will remain involved in markets, says Peter Randall, who helped to develop Chi-X Europe into Europe’s largest share trading platform.

To explain why, he draws a comparison between trading and modern aviation.

A commercial jet can, he says, take off, fly and land without a person at the helm. In fact, a pilot cannot fly a jet without the use of computer systems any more. But having a pilot is essential if there are problems.

The situation is the same in markets and Randall is adamant that HFT is a positive thing for investors. “It’s easy for investors to get upset about things like this, but why should you care whether you are buying stock from another retail investor or a high-frequency trader?” he asks. “I don’t think it’s something that should damage investor confidence. I think it’s enabling.”

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No consensus on the need for speed

Across the world financial regulators are wondering what, if anything, they should be doing to clamp down on high-frequency trading.

Ideas range from giving authorities the power to slow down machines, setting a transaction tax that would make small, high-volume trades less profitable and setting minimum resting times so that orders have to stay in the market for a set time.

So far, there is no consensus.

In Europe, authorities plan to use the review of the Markets in Financial Instruments Directive (Mifid) to put controls in place, with the European Parliament voting in favour of orders being forced to remain in the market for a minimum of 500 milliseconds.

Deals in nanosconds

If supermarkets ran HFT programs, the average household could complete its shopping for a lifetime in under a second.

This was the analogy used by Andrew Haldane, the Bank of England’s executive director for financial stability, in his 2011 speech on high-frequency trading (HFT).

The rise of machines means that trading times have fallen from minutes to seconds to milliseconds and now microseconds. According to Haldane, the new frontier is nanoseconds – billionths of a second.

Another way to try to understand these super-human speeds is to use measures of time that we are more familiar with. A nanosecond is to one second what one second is to 31.7 years.

These speeds means that tiny fractions of time can make the difference between an HFT company being the first to make a trade or being beaten by a competitor. To gain an advantage, companies not only spend millions on technology, but also reduce “latency” by closing up the physical distances and placing their servers as close as possible to the exchanges’ data centres.

Individual countries want to go further. Germany is proposing to license financial market participants in order to tighten regulation and last month Deutsche Börse said it would charge traders if they sent in too many orders that did not result in deals. In Italy, politicians recently introduced a financial transactions tax of 0.02 per cent tax on orders issued and then cancelled within half a second.

Australia wants high-frequency traders to have a “kill switch” to prevent future flash crashes and is considering a tax charge, while in the US the Commodity Futures Trading Commission (CFTC) has begun a review of HFT following a new rule that requires brokers to have better risk controls. It is also looking into the possibility of installing “circuit-breakers” on individual stocks to prevent sudden price swings.

The UK’s report into HFT, published in October 2012, argued that regulation of high-speed trading needed to be co-ordinated across markets. It wants authorities to consider a central European data centre that could be used to analyse trades.

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Legacy of the ‘flash crash’

On May 6, 2010, US equity markets suddenly and mysteriously plunged and rebounded in less than half an hour.

The “flash crash” was short, but it was enough time for the equity prices of some of the world’s biggest companies to fluctuate dramatically. Shares in management consultancy firm Accenture, for example, dropped from $40 to 1 cent. Procter & Gamble’s share price fell 37 per cent at one point.

Although prices quickly sprang back up again, some investors lost out as a result of the crash, including one US investor in the US who lost $17,000 because his order to sell shares in Procter & Gamble – spurred by his worry about what was happening in the market – was executed just after prices fell.

The official report located the source of the problem to a large order from a single institutional investor which then triggered rapid automated selling by other traders, including high-frequency traders.

But experts still don’t really know why this “near miss” happened, or how to prevent it happening again. Technology allows firms to trade ever faster, but it also magnifies problems when they occur, at speeds that no human can hope to keep an eye on.

Since 2010 there have been other, smaller, glitches, including the software failures that delayed the opening trade of Facebook’s initial public offering.

But one of the most alarming problems occured in August 2012 and sent Knight Capital, the Wall Street brokerage firm, close to bankrupcy.

The company had installed new software which then appeared to be making trades the company didn’t intend. Unwinding the purchases of shares made in just 45 minutes has so far cost the company half a billion dollars.

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