The wolf in sheep’s clothing: HFT is not the preserve of retail traders, but its institutional usage is affecting liquidity

Two years ago, many industry executives in retail FX brokerages, as well as specialist liquidity providers, platform companies and connectivity firms had focused a significant amount of attention on high frequency trading, or HFT as it is often referred to in its three-letter acronym form.

Discussions within bank desks, through to the boardrooms of some of the world’s largest non-bank dealers had opinions on the increasing use of high frequency trading practices within the proprietary trading desks of Chicago, as well as those connected remotely via colocated servers to venues in Australia, Japan and Singapore.

The attention of the regulators was attracted, and Germany, a nation with very little electronic financial markets activity compared to the powerhouses of London and Chicago, was the first to show concerns with regard to high frequency trading within its jurisdiction, as the regulator invoked a High Frequency Trading Act which went into force in May 2013, covering supervision, risk controls, limiting the order-to-trade ratio and tick size, and ordering venues to flag all electronic and algorithmically generated orders with a unique key when sent to a German exchange – and perhaps most of all, the implementation of strict rules regarding market manipulation.

High frequency news analytics services had begun to give institutional traders an edge by speeding up reaction times to new information, and BaFIN’s view on potential market disruption that this can cause when connected to a low latency execution system, led the way toward the US authorities and the European Commission to take a look at whether to put a complete stop to it.

High speed news + low latency connection = disruption or progress?

Institutional traders in financial markets had been increasingly sourcing information from ‘sentiment’ indicators; analytics created by computer algorithms from real-time content published by Dow Jones Newswires, Bloomberg, Thomson Reuters and other wire services.

These indicators can tell traders within milliseconds whether an article is positive or negative and whether it contains relevant information affecting the value of an asset, as well as giving a trader the ability to connect to a very low latency system which can outpace that of a standard retail trading environment, confident that the high frequency analytics will keep up with the speed of the trading system and therefore provide an advantage via ‘latency arbitrage.’

The Dodd-Frank Act’s introduction in 2010 included the “Volcker Rule” which was named after veteran American economist Paul Volcker, which sought to ban proprietary trading which takes place outside of banks. This was set to change the entire landscape of Chicago’s prop desks, however when it was invoked, it outlawed proprietary trading by non-bank institutions by any instrument except for OTC derivatives.

Australia, land of plenty, rich in minerals and as a result home to a massive and highly profitable commodities trading industry, largely centered around minerals, took the view that HFT and the use of algorithms is part of the financial landscape. Astute regulator ASIC is renowned for ensuring a very high quality financial markets economy, however it sees no issue with algos.

All gone quiet…  but has it?

Despite the ongoing advancement of the retail FX trading environment, HFT and the use of algorithmic solutions in the same form that they are used by commercial desks are two facets that have not made their way into the hands of retail customers as yet, and apart from a few specialist systems which emulate the colocation of servers that commercial companies go to great expense in order to achieve, the entire HFT discussion has gone quiet among the boardrooms of the retail giants, technology vendors and ancillary service providers in the same way as it has done within the offices of the regulators.

During 2009 and pre-Dodd Frank 2010, approximately 60% to 70% of U.S. trading was attributed to HFT, though that percentage has declined in the last few years.

Why this perhaps should be brought onto the main stage yet again is that although the use of HFT and algorithms in professional settings has declined by a small amount, it is still there and it is perhaps worth considering that although it has remained the preserve of the corporate trading world and has not filtered into retail, today’s difficulties with liquidity relationships for brokerages and non-bank liquidity providers is not just down to the counterparty credit risk issue that blights the entire business currently.

A combination of difficulties obtaining credit for spot transactions on an OTC basis and the effect that HFT has on liquidity provision should be a current situation to bear in mind.

In terms of less liquid assets such as stocks, liquidity is measured during the five secodns after the release of a news item is lower for articles accurately portrayed as being of high relevance than for high-relevance articles originally released as low-relevance.

This suggests that while trading on news analytics improves the informational efficiency of stock prices, the fact that only a subset of market participants has access to news sentiments indicators increases information asymmetry in the market.

Two years ago, online international business school INSEAD conducted a study with regard to how the risks of high speed analytics can affect everything from price to liquidity.

At the time, the researchers looked at both Ravenpack’s initial and corrected analysis taken from the Dow Jones articles (the initial analysis being largely “written” by algorithms, while the corrected version is edited by a human).

Effect on volume and liquidity – Prop trading institutions use advantageous methods, FXPBs pay the price.

Two important findings were that market news articles recognized early as being of high relevance triggered a significantly greater ratio of trade volume for the asset within the first five seconds compared to news releases which ere initially but inaccurately being regarded to be of low importance.

Translate that into today’s environment, in which banks, themselves making losses, are looking to reduce the risk that they take by providing Tier 1 liquidity directly to non-bank prime brokerages , with a total risk weight for probability of default having been calculated at 56.60% by across the entire interbank FX dealers as part of a study by Citigroup last month, and it displays another obstacle to overcome, which this time is absolutely not the creation of the retail FX world, but a byproduct of the institutional closed desk environments.