While the US looks into high-speed trading, in Europe the market continues to grow
IRELAND’S INTERNATIONAL Financial Services Centre (IFSC) was to bring front-office trading activities to Dublin, over two decades on it seems that to some extent, it may finally be happening.
In among the back office operations, the fund administrators and the professional services firms lining Dublin’s docklands are a group of proprietary trading firms, largely originating from the US, who have come to Europe to exploit opportunities arising from technological advances.
While they may have kept a low-profile up until now, investigations by the US regulator Securities and Exchange Commission (SEC) into techniques such as flash and high-frequency trading (HFT) has brought them into focus. HFT involves the use of computer-based algorithms to replace phone-led orders.
According to Kieron O’Brien, a director with Rosenblatt Securities, a US boutique agency with a Dublin operation, it is the “extension of the electronification of the market”.
As the name suggests, HFT is fast. Traders use computers to execute thousands of orders a second, which, critics say, gives high-frequency traders an unfair advantage over ordinary investors and is leading to a two-tiered market. For many, HFTs are the new hedge funds, with new outfits opening up every day and attracting talent away from more traditional firms. “These are the new bulge bracket firms, replacing the Citigroups and Goldmans,” says O’Brien.
HFT first emerged in the US about a decade ago, but in the last two to three years it has become very popular with arbitrage/quant houses, accounting for about 50-60 per cent of daily volume in US equity markets.
The emergence of such techniques is due in part to the radical transformation in how trades are transacted over the last few years. Traditionally, exchanges such as the New York Stock Exchange and the London Stock Exchange (LSE) would have handled more than 80 per cent of all transactions, but now the market has fragmented and in addition to the mainstream exchanges are so-called “trading venues”.
In Europe, trading venues or multilateral trading facilities (MTFs) such as Chi-X, Turquoise and Euro Millennium, which provide a pan-European trading ability on a single platform, have eaten into the market share of the major exchanges. Chi-X, which was the first MTF to launch in Europe in 2007, now has a 23 per cent market share of the FTSE 100 and a 21 per cent share of French index, the CAC 40. The LSE’s share of UK trades has dropped from about 85 per cent to 50 per cent, while closer to home, the Irish Stock Exchange has long since focused its efforts on niche areas such as debt and funds listings.
The rise of HFT has grown hand in hand with the MTFs, due to the “major taker” pricing model, whereby trading firms are offered a reward – or rebate – for providing liquidity in particular markets.
According to O’Brien, HFTs manipulated the pricing model to always be on the rebate side. So, in addition to being able to process orders super fast, high-frequency traders also pick up rebates on each order, which means that it is a very profitable business. Estimates from Tabb Group suggest that high-speed stock traders banked about $21 billion in profits last year – despite the global financial crisis.
In the US, there are more than 50 trading venues. The Tabb Group estimates that high-frequency trading firms now represent more than 61 per cent of the daily trading volume in stocks. Given such concentration, opponents argue that HFT poses a systemic risk.
Where both critics and proponents generally find agreement however, is the use of “flash trading” by some high-frequency traders to get an additional advantage over their peers. Flash trading emerged when, following on from the major taker model, trading venues extended the incentives available to HFT operations to get them to provide liquidity by giving them a first look at prices as a reward, the so-called “flash trading”.
These prices are displayed on certain exchanges for less than 500 microseconds, which means that only those with the fastest computers can see and act on them. It is this information asymmetry which is raising the ire of flash trading critics.
In a speech to President Barack Obama to mark the anniversary of the collapse of Lehman Brothers earlier this month, Senator Edward Kaufman, one of the more vocal opponents of high-frequency trading, criticised it as allowing “one market for huge-volume, high-speed players, who can take advantage of every loophole for profit, and another market for retail investors, whose orders are seemingly filled as an afterthought without any special priority”.
O’Brien himself concedes that the SEC should regulate flash trading “as any type of elitist order type wouldn’t be of benefit to the general public”, but argues that HFT shouldn’t be penalised, given that similar practices have been in operation for decades.
“The New York Stock Exchange is arguably the biggest ‘dark pool’, where a chosen group of floor traders and specialists get first look at the prices,” he says. Moreover, flash trading is only used by some high-frequency traders and such orders only account for about 3 per cent of overall flows.
The SEC is looking into the issue and a ban on flash trading is seen as likely. Whether it will go another step and move to ban HFT is another issue, but it is looking at a wide range of “market structure issues”, including HFT.
While the US continues to investigate such trading techniques, in Europe the market continues to grow. A big driver of the market was the introduction of the Markets in Financial Instruments Directive (MiFID) in 2007, which allowed the creation of MFTs, which in turn attracted US trading firms to seek out opportunities in Europe.
Which leads us back to Dublin. While Amsterdam may be the hub of high-frequency trading in Europe, several firms have already set up their European operations here, while other US operations are said to be considering making similar moves.
Given that the business is technologically driven, trading firms are no longer confined to the traditional sites of London, Paris or Frankfurt. So Ireland’s low corporate tax rate is a major incentive for such profitable firms.
Susquehanna is a market maker and liquidity provider in a wide variety of securities, commodities and other financial products, including options, ETFs and other derivatives. It employs more than 140 people at its European headquarters in Dublin.
Another proprietary trading firm, Geneva Trading, was set up in Dublin in 1999 by two traders who began began their careers on the floor of the Chicago Board of Trade, and has since grown into a global proprietary trading firm, with offices in Chicago and Cork, employing more than 100 people.
More recently, Madison Tyler, an electronic trading firm and market maker opened its doors in Dublin, while Virtu Financial, a New York-based proprietary trading firm that employs sophisticated algorithmic trading strategies across major electronic marketplaces worldwide, is in the process of setting up an Irish operation.
However, if Ireland is really to capitalise on the opportunities presented by this new form of trading, its technology will have to catch up, given how important this is to the industry. As Madison Tyler describes itself, it is “as much a technology company as a trading company”.
“Unless we can provide them [HFT firms] with super fast low cost technology, we will find it very difficult,” maintains O’Brien.
