Hot debate on the impact of HFT

In the U.S., IEX Group Inc., due to start trading at the end of October, is backed by a variety of mutual funds, hedge funds and other investors, led by a former trading executive with New York-based RBC Capital Markets LLC.

Similarly, Aequitas Innovations Inc. is proposing to create a new exchange here in Canada that would exclude HFTs. Aequitas was founded by several companies on the “buy” side and in the trading business, along with Royal Bank of Canada. This venture is drawing broad support from other financial services industry players – including fund portfolio managers and financial advisors – in the initial public debate over Aequitas’s plans, which still must win regulatory approval.

Despite this widespread support for efforts to combat certain forms of HFT, its impact on the markets remains hotly debated.

Intuitively, it would seem that HFT is likely to harm the interests of other market players because many HFT strategies aim to exploit technological advantages over other traders and to profit simply from the ability to do things faster than other market players. This doesn’t contribute new information to the market or strive to improve the efficient allocation of capital.

Moreover, there’s a sense that HFT imposes needless costs on both the investment sector and regulators by ramping up message traffic, to the point that firms and regulators must invest in ever-better technology just to be able to handle the volume of data being generated.

Yet, the debate over HFT rages on. The Investment Industry Regulatory Organization of Canada (IIROC) has been studying HFT over the past couple of years. The first phase of IIROC’s research merely aimed to profile traders with high order/trade ratios (so-called “HOT traders”), but didn’t attempt to assess their impact on the market. On Nov. 21, IIROC is holding a market structure conference, along with the Ontario Securities Commission, in which IIROC is expected to present the latest results of its research.

In the meantime, the C.D. Howe Institute published a report in mid-October by University of Toronto law professor Jeff MacIntosh that defends the impact of HFT. That report argues that HFT enhances market quality and benefits other traders – both retail and institutional: “It lowers bid/ask spreads, reduces volatility, improves short-term price discovery and creates competitive pressures that reduce broker commissions.”

Overall, this benefits retail traders, the paper argues. And, these benefits challenge the notion that HFT harms markets or is to blame for episodes of apparent market fragility, such as the “flash crash” that occurred in May 2010.

Indeed, the C.D. Howe report suggests that regulators should be removing barriers to HFT, arguing that regulators should not interfere with the maker/taker pricing models used by many exchanges to attract HFT. Moreover, the report says, rules against trading amid “locked markets” should be abolished and routing to different trade venues should be randomized to enhance the ability of smaller, upstart markets to compete. The report also argues that regulators should maintain the “order protection rule,” which is central to the debate over the trading model that Aequitas proposes.

In addition, the C.D. Howe report recommends that IIROC scrap its new fee model that charges for message traffic – a measure that was introduced in April 2012 and which reportedly has reduced HFT volumes as a result – and return to charging fees based on trading volume.

A new working paper from a couple of economics professors at the University of Toronto, Andreas Park and Katya Malinova, along with a professor at the University of Ontario Institute of Technology, posits that this new fee model is affecting both HFT traders and more traditional retail and institutional investors.

The professors’ joint research, which focused on the apparent impact of the IIROC fee model change, concluded that message traffic (orders, trades and order cancellations) dropped by 30% after the new fee rule took effect and that bid/ask spreads rose by about 9% as a result, which, in turn, increases costs to all traders. Says the paper: “We find that the reduction in high-frequency quoting leads to an increase in retail traders’ costs and to a decrease in their intraday returns.”

However, the same research also found that intraday returns for institutional traders have increased in the wake of the rule change, despite the higher transaction costs. The paper suggests that HFT affects retail and institutional traders differently and that: “It may lead to redistribution of gains from trade between retail and institutional traders.”

Of course, as the paper notes, many institutional traders, such as mutual funds and pension funds, are managing money for retail investors. So, although it may appear that institutional traders are benefiting at the expense of retail traders, certain retail investors ultimately may benefit from this shift, too.

This finding, that HFT may particularly harm the interests of institutional investors, is echoed in new research by Lin Tong, a graduate assistant at the University of Iowa’s business school. Her paper, released earlier this autumn, notes that while most of the empirical evidence suggests that HFT does improve market quality, “this improvement does not immediately lead to more efficient trading for traditional investors.”

In fact, this paper reports both “strong evidence” that HFT increases the trading costs of traditional institutional investors in the U.S. and validates one of the frequent criticisms of HFT – that the liquidity this type of trading adds can be illusory.

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