High-Frequency Traders May Accept More Risk, Liquidnet SaysNina Mehta
Some high-frequency trading firms will transact blocks of shares away from exchanges as pending regulations restrict some of their activities, according to analyst Vlad Khandros at Liquidnet Holdings Inc.
The prediction was 1 of 11 that Khandros, a market-structure and public-policy analyst, sent to some of New York-based Liquidnet’s 630 mutual fund and hedge fund clients today. He also said high-frequency trading, in which firms may transact thousands of times a second, will become an “accepted and defined” category of market participants this year.
Executing bigger trades off exchanges will help companies comply with planned rules from the U.S. Securities and Exchange Commission to limit the ability of venues to solicit trading interest through electronic messages, Khandros said. The SEC is likely to approve the rules for dark pools, or private venues that execute orders without publicly displaying buy and sell requests, as well as certain brokers, he said. Liquidnet operates two dark pools in the U.S. and trades in 38 countries.
“What the SEC is trying to do is restrict some of the activity on these venues that don’t give what they deem material price improvement or size improvement on trades,” Khandros said. “Those handling large orders will be able to source liquidity more freely than other venues, and firms willing to take on greater risk will have more opportunities.”
More Right Than Wrong
Khandros says he got 6 of 10 predictions for 2010 right. He guessed that U.S. takeovers would see a “massive uptick” and share repurchases by corporations would increase. Announced mergers and acquisitions rose 22 percent to $779.5 billion in 2010, according to data compiled by Bloomberg. Last year was also the fourth-biggest for announced buyback plans, according to Birinyi Associates Inc. data going back to 1985. Planned buybacks tripled to $373.4 billion, the data showed.
Liquidnet was wrong a year ago when it said two of three social media companies -- Facebook Inc., Twitter Inc. and LinkedIn Corp. -- would sell shares in an initial public offering by Dec. 31.
The SEC proposed rules in November 2009 to curtail the growth of those dark pools that send out electronic messages seeking matches for orders they already hold. The proposal treats indications of interest, or IOIs, that can be immediately executed as orders requiring public display, although it permits an exception for requests to buy and sell blocks of shares valued at $200,000 or more. Liquidnet expects that level to be tuned for stocks based on their market capitalization.
Khandros said dark pools, high-frequency traders and brokers will struggle to differentiate themselves from rivals this year, especially with U.S. trading volume in decline. Last year’s average daily equities volume was 8.52 billion shares, down from 9.77 billion in 2009, according to data compiled by Bloomberg. Daily volume this month through yesterday was 8 billion shares, down from 8.3 billion during the same period a year earlier.
Pipeline Trading Systems LLC, Liquidnet’s main dark pool and Investment Technology Group Inc.’s Posit Alert had average trade sizes of more than 35,000 shares, with Pipeline the largest among the non-displayed venues surveyed, according to a Dec. 21 report by Rosenblatt Securities Inc.
Khandros said the SEC will probably impose obligations on market makers and firms providing a similar function, requiring them to quote at the national best bid and offer, or NBBO, a certain percentage of time -- and perhaps for a specified number of shares. After the May 6 plunge that erased $862 billion in equity value in about 20 minutes, SEC Chairman Mary Schapiro said the agency is considering stiffening requirements.
‘Take More Risk’
“Regulators are taking actions that will force high-frequency traders to take more risk,” said Manoj Narang, founder and chief executive officer of Tradeworx Inc., a Red Bank, New Jersey-based high-frequency firm. He said his company, which mostly trades exchange-traded funds, accounts for up to 4 percent of the daily volume in the SPDR S&P 500 ETF Trust.
“Regulators are a bit uncomfortable with the idea that small and poorly capitalized traders can participate in the equity markets to the extent they do,” Narang said. “But it’s a misguided belief on the part of regulators, and it’s bad for the market because it’s uncompetitive.”
He cited the prospect of market-maker obligations and the SEC’s November ban on unfiltered access, or naked access, in which firms send orders to markets without passing through the risk checks of their brokers. The rules benefit larger traders and disadvantage smaller firms that won’t be able to trade as rapidly as their rivals or at the NBBO a set percentage of the time, he said.
“That entrenches large, well-established players who used sponsored access in its old form to get to the level they’re at now,” Narang said. Sponsored access refers to multiple practices allowing customers to access markets directly using a broker’s identification code. “That path has been cut off for smaller firms, immunizing bigger firms from competition,” he said.
Jamie Selway, a managing director at ITG, said in his predictions for this year released last month that a dearth of institutional orders for high-frequency firms to trade with and rising technology and operational costs “culls the herd a bit.” Criticism of the high ratios of canceled orders to trades by those firms will push several stock exchanges this year to levy charges when high numbers of orders are withdrawn, he said.
The trend of high-frequency trading will “explode” in Singapore, Japan, South Korea and Australia this year, while Hong Kong won’t experience similar growth, Khandros said. Tokyo Stock Exchange Group Inc. introduced its Arrowhead trading system last January while ASX Ltd., which operates Australia’s primary market, in December upgraded to a new platform based on Nasdaq OMX Group Inc.’s Genium INET technology in a bid to woo firms that engage in rapid trading.
Khandros said Hong Kong’s stamp tax of 10 basis points, which “effectively keeps out” high-frequency firms by reducing the profit they make on trades, isn’t likely to be eliminated in the near term. A basis point is 0.01 percentage point. High-frequency trading accounts for more than half of U.S. equity volume and a growing portion in Europe and Asia.
The SEC is also likely to update rules from 1982 governing how corporations purchase their own shares in the market within a so-called “safe harbor” protecting them from liability for stock-price manipulation, Khandros said. The commission proposed altering Rule 10b-18 a year ago to allow for more advanced algorithms or trading strategies used to execute bigger orders in smaller pieces.
“The intent of some of the conditions 30 years ago was to prevent issuers from intentionally driving up the stock price, but the result was the opposite,” Khandros said. “Trading firms can see a 10b-18 algo a mile away because it’s a very clear pattern, so they can push up the price. It needs to be updated to lower the cost of buybacks for corporate and bring more liquidity to investors.”
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