High-Frequency Trading Winners and Losers

Published by clickbroker.blogspot.com

The Wall Street Journal’s “What's Behind High-Frequency Trading” provides a pretty good Q&A on how Goldman Sachs (GS), Citadel and various smaller specialty firms take advantage of advanced peaks at orders, exchange rebates and flash orders that can be withdrawn in a split second. A political furor is starting to emerge from highly leveraged firms front running orders and teasing prices fractionally up, at the expense of mutual funds and other large institutional investors.

With firms jockeying for the closest physical proximity to the exchanges data centers, NYSE Euronext is building a huge data center in New Jersey to accommodate them. The exchange will be renting space in its own multi-football field size data center to house the computers of high-frequency traders. That’s how critical the speed of light along fiber optic cables is to this form of making money.

Aside from some inherent unfairness, what has regulators and politicians concerned? First is leverage, especially with the small firms specializing in this extreme form of programmed trading. Second is the systemic risk of large trades gone wrong. Third is the cascading effect of copy cat strategies. Think of how seriously flawed the portfolio insurance schemes of the 1990s were when they encountered a few black swans.

While mutual funds and large institutions are marginal losers, the exchanges are obvious winners with increased volume. Typically institutional traders don’t use limit orders for fear of tipping their hand, so any market manipulation hurts their clients. In a very real way high-frequency traders, such as Goldman, are trading against their own clients.

The story is mixed for retail investors. Most firms no longer charge higher commissions for limit orders, so higher volatility increases the likelihood that retail orders will be filled. Investors that are not pressured to buy or sell in a certain time frame are clearly winners.

Retail “active” traders that favor market orders could be buying or selling at a slightly disadvantaged price. Also they could be fooled by a false sense of momentum.

Retail investors that are dependent upon gradual investment sales for living expenses are most vulnerable. It can also be said the retail mutual fund shareholders will suffer slightly lower returns. But, investors in low churn funders should not be concerned.

If regulators rein in on this form of front running and insure firms have the capital to cover their risk, I see little harm in high-frequency trading. In many ways high-frequency trading has the same risks and benefits as programmed trading on the news.

No Disclosures.

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