The Canadian National Post newspaper has just run an article on high frequency trading, which has made its way north of the border in spectacular style. According to the Post, the Toronto Stock Exchange (the TSX) was the venue for some 99.5% of trades in the largest 60 Canadian quoted companies one year ago: in a mere twelve months, this percentage has fallen to just 69%. The winners are new, so called "alternative exchanges", which appear to be favoured by high frequency traders.
Such a shift in trading patterns is pretty dramatic by any measure. When thinking about this, we certainly agree that any trading strategy which increases exchange volumes can be good - more volume can increase price transparency, make it easier to fill orders (especially smaller orders from retail investors), and reduce bid ask spreads.
On the other hand, you have to take a step back and ask how high frequency traders make their money. Exactly why is it that these traders need a computer data centre of the size usually reserved for manned space missions? Exactly what informational, mathematical or regulatory advantage are these traders exploiting to make money as they place orders for millions of shares a day, in and out of names many times during each trading session?
The SEC has already focused on the practice of "flash orders" whereby certain investors could access information about order flow a half second ahead of other market participants. At first glance, you have to ask what possible difference a half second could make - until you realize that a half second is a very long time when you have Google levels of computing power. Dark liquidity pools and other off exchange trading also seems to be an area of current regulatory focus (see a recent Bloomberg article for a summary of these developments.)
The National Post quotes Joe Saluzzi of Themis Trading, who comments: "What these guys are about is speed, and they are getting access to quotations before the general public…so, in essence, they are re-engineering the quotes by jumping between you and the seller". He continues: "most investors don't even realize they are losing money, because their pockets are getting picked without them even knowing it. The price you paid may have been inflated during the day, because they are taking advantage of the order flow and you don't even know it."
To be clear, our comments are as an interested observer rather than an informed opponent (or proponent) of high frequency trading. As above, volume and liquidity have many powerful advantages, and perhaps high frequency orders are the "wave of the future".
On the other hand, we do hold our hand up as professional skeptics. The fact that a small group of trading entities with Fortune 500 style IT budgets can make a very profitable business out of high frequency trading raises our common sense antennae. The reason, of course, is that there is no retail investor who could deploy the same trading technique - a Dell desktop simply won't cut it. High frequency traders therefore have an advantage which is unavailable to the "average" investor.
It's always good to bear in mind that much of investing is a zero sum game - someone makes money, with the unavoidable implication that someone else has lost it. The skeptic in us, therefore, is reminded that it isn't always a great idea to bet too heavily on strategies which allow a small group of investment insiders to make money at the expense of the little guy.
That, of course, was the lesson of mutual fund timing.
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