High-Frequency Traders Chase CurrenciesJohn Detrixhe, Nikolaj Gammeltoft and Sam Mamudi
Forget the equity market. For high-frequency traders, the place to be is foreign exchange.
Firms using the ultra-fast strategies getting scrutiny thanks to Michael Lewis’s book “Flash Boys” accounted for more than 35 percent of spot currency volume in October 2013, up from 9 percent in October 2008, according to consultant Aite Group LLC. It’s the opposite of equities, where their proportion shrank to 50 percent in 2012 from 66 percent four years ago, according to Rosenblatt Securities Inc.
As brokers get better at cloaking orders and volume shrinks in stocks, speed trading remains a growth business in the $5.3 trillion foreign-exchange market, where authorities on three continents are examining the manipulation of benchmarks. While some see them as a sign of transparency, the tactics are catching on just as their role in equities is probed by the New York state attorney general and Federal Bureau of Investigation.
“The use of HFT will make trading and regulation in the FX market more complex, and there would also be some questions over the fairness,” Anshuman Jaswal, senior analyst at research firm Celent in Boston, said by e-mail. “Use of HFT also increases liquidity and depth in markets. Both sides of the argument carry some weight, and there is no one right answer.”
The debate surrounding high-frequency trading, a term describing strategies that use lightning-fast computers to eke out profits in securities markets, blew up this week after Lewis published “Flash Boys” and said U.S. equities are rigged. The book makes few references to currency, saying instability HFT creates is bound to spread from equities sooner or later.
About 30 to 35 percent of transactions on EBS, an electronic trading platform owned by ICAP Plc that facilitates currency deals, are high-frequency driven, the Bank of International Settlements said in a December report. The rise in electronic and algorithmic trading is prompting firms to set up shop close to the servers of electronic platforms, a strategy to reduce transmission time that has long been popular in stocks.
High-frequency strategies flourished in American equities as rising computer power and two decades of regulation broke the grip of the New York Stock Exchange and Nasdaq Stock Market and trading spread to more than 50 public and private venues. Now, speed traders are proliferating in foreign exchange.
“Any of the big names that are involved in the equity side are generally starting up FX businesses as well,” Brad Bechtel, managing director at Faros Trading LLC in Stamford, Connecticut, said of high-frequency trading in a phone interview.
“FX has ongoing liquidity throughout the day, no interruption in trading and fewer gaps in prices, which all allow for algorithmic trading to flourish,” Javier Paz, a senior analyst at Boston-based Aite Group, said in a phone interview. “Add to that the sheer size of the FX market and the limited number of traded products compared to equities, which means the liquidity tends to concentrate, creating tradable opportunities for high-frequency firms.”
Advocates of computer trading see the rising role in currencies as a blessing, its arrival a harbinger of transparency in a market beset by scandal.
The currency market is under scrutiny amid investigations into whether traders at some of the world’s largest banks sought to manipulate the WM/Reuters rates in their favor by pushing through trades before and during the 60-second windows when the benchmarks are set. Regulators are examining whether bank traders communicated with dealers at other firms and timed trades to influence benchmarks and maximize profits.
“With HFT, we have transparency of prices,” Irene Aldridge, managing director of New York-based Able Alpha Trading Ltd., a high-speed investment solutions firm, said in an e-mail. “Brokers can no longer give preferential pricing to some clients at the expense of others.”
That’s not the picture painted by Lewis, who wrote that the U.S. stock market is rigged by high-frequency traders who make tens of billions of dollars jumping in front of investors. Everyone who owns equities is victimized by the practices, said Lewis, a columnist for Bloomberg View.
While speedier strategies are becoming “really prevalent” in foreign exchange and some are predatory, many are “rather benign and provide liquidity to the market,” said Aaron Smith, managing director and co-founder at Pecora Capital LLC.
“We see plenty of strategies that depend on low latency and co-location in London or New York,” Smith said in a phone interview from Zurich. Some of the company’s portfolio, which includes currencies, is traded with systematic methods, with holding periods of a few hours to a few days, he said. Still, there are other issues to consider.
“We don’t want to be in the high-frequency space because then you’re in a technological foot race against the next guy,” Smith said. “When they have a bigger, faster, stronger computer, you’re out of business. We’re not interested.”
Bloomberg Tradebook operates an electronic communication network for currencies that is used by both the buy side and the sell side to trade anonymously using a variety of trading strategies.
New York Attorney General Eric Schneiderman has opened a broad investigation into whether U.S. stock exchanges and alternative venues provide high-frequency traders with improper advantages. Schneiderman said March 18 he’s examining the sale of products and services that offer faster access to data and richer information on trades than what’s typically available to the public.
The FBI’s inquiry stems from a multiyear crackdown on insider trading, which has led to at least 79 convictions of hedge-fund traders and others. Agents are examining, for example, whether traders abuse information to act ahead of orders by institutional investors, according to an FBI spokesman. Even trades based on computer algorithms could amount to wire fraud, securities fraud or insider trading.
Peter Donald, a spokesman for the FBI in New York, and Matt Mittenthal, a spokesman for Schneiderman, declined to comment on whether their probes of high-frequency trading included foreign exchange.
While trading against HFTs isn’t easy, they are helping the market by providing more liquidity, Axel Merk, the founder and president of Palo Alto, California-based Merk Investments LLC, which oversees about $400 million of foreign exchange, said in a phone interview.
“I don’t think it’s very helpful to wholesale say HF shops are bad,” Merk said. “When you’re dealing in the market, you’re not dealing with friends. You’re dealing with somebody who wants to make money off of you. That is the definition of a market. The other person is out there to get a better deal.”