Don't believe the hype
Intense competition among high-frequency
trading (HFT) firms to provide liquidity could actually be raising costs for
institutional investors and require regulators to rethink some elements of US
market structure, according to David Mechner, CEO, Pragma.
HFT firms are considered by their
proponents to provide a valuable market making service to the market – a notion
that Pragma, which specialises in broker-neutral electronic trading firms – has
recently put to the test.
Recent research from the firm has found some
of the most liquid blue-chip stocks often have disproportionately long queues
because of the large number of HFT orders competing to provide liquidity,
compared to aggressive orders taking liquidity from the order book.
“For low-price, high-volume stocks, there
are market structure issues making it extremely lucrative to be a market maker
in these stocks,” says Mechner. “This creates a crowding effect that can
disadvantage long-term investors.”
The extreme competition in liquidity
provision for cheap, liquid stocks can force institutional investors to cross
the spread to complete their orders in a timely manner, which can raise trading
“If market making in these stocks was not
as competitive, long-only traders would have the opportunity to interact with
each other directly and keep the spread between themselves, as opposed to
paying it out to HFT firms,” adds Mechner.
Much of this problem can be solved by
fine-tuning tick sizes – the minimum increments at which stocks can be traded –
and maker-taker pricing, a tariff used by most US trading venues that pays
members for providing liquidity to the order book and charges them for removing
In the US, tick sizes for stocks below US$1
are US$0.0001, while stocks priced above US$1 are US$0.01. A spread of US$0.01
for popular low-priced stocks, such as Bank of America, which is currently
trading at around US$7.75, makes it cheap for HFT firms to provide liquidity,
but makes it extremely costly for buy-side firms to cross the spread.
“Having a lower tick size would allow the
bid ask spread to come to a more reasonable equilibrium for low-value stocks,”
says Mechner. “The result would be a reduction in effective spreads and execution
costs for institutional investors.”
US regulators could look to the tick size
regime used in Europe, which has a more nuanced regime that uses up to 11
different tick size bands depending on the price of a stock.
The dynamic used for tick sizes is also
true for maker-taker pricing. On Nasdaq OMX, for instance, the rebate for those
firms that provide liquidity in stocks priced over a dollar is US$0.0029 per
share, dropping to US$0.00009 per share for stocks priced under a dollar.
“Exchange rebates effectively act as a
subsidy to market makers and exacerbate the crowding effect,” states Mechner.
“If you are forced to cross the spread, you also have to pay the rebate, which
goes straight to the liquidity provider. More standardised tariffs from exchanges
would reduce trading costs for buy-side firms in these instances.”
But given the technology errors which have
plagued the US market in recent years – including the recent Knight incident
which saw the US market maker lose US$440 million in 45 minutes – Mechner doesn’t
expect regulators to act on any of these issues any time soon.
“There has been a lot of debate around HFT,
but the focus of regulators is on systematic issues,” says Mechner. “This is
entirely understandable as first and foremost, markets need to be reliable. But
while reducing frictions and misalignments is a secondary concern, it is still
an important one.”