If you’ve listened to the market structure debate over the past few years, you’d think large, institutional investors — the “buy side” — desperately need ‘speed bumps’ and other barriers to protect them from high frequency trading (HFT). The discussion has been more about demonizing than data, except that it ultimately led to a well-publicized regulatory exemption for intentional delays that has only served to make the markets more labyrinth than linear. But in the background, a quieter and more important development is changing the buy side/HFT relationship and it is redefining the nature of liquidity provision.
Despite lots of ‘Chicken Little’ warnings, large asset managers are realizing the benefits of HFT tools – and the liquidity providers that use them. They are forging new partnerships while choosing to ignore what famed investor Cliff Asness calls the “fusillade of hyperbole about HFT practices.” And it is easy to see why. As Bloomberg reported in its story Wall Street’s Speed Demons Are Heroes, “Since 2013, positive research (on the role of HFT in the markets) has outnumbered negative by a 2-1 margin.”
A steady stream of news tells of greater collaboration between the buy side and HFT intermediaries. Daniel Coleman, CEO of trading firm KCG, said his company continues “to grow algorithmic trading among the leading U.S. asset managers.” Citadel Securities has become a leader in the interest rate swaps market, streaming prices directly to institutional clients. And high-frequency trading firm Virtu launched a “velvet rope” service to execute trades for “select institutional investors” and has partnered with J.P. Morgan Chase, T. Rowe Price, and German asset manager Union Investment.
State Street recently released a report that found 48% of buy side institutions say they will increase their use of electronic trading platforms in order to access more liquidity. Many of these firms would even consider becoming market makers themselves, but we suspect the technology costs and complexity of market structure keep them away. So why not “outsource” market making to the firms with the best HFT tools?
Perhaps the biggest factor weighed by any market intermediary when supplying liquidity is the fear of getting run over by large, unforeseen institutional trades. It seems reasonable that if that risk could be tempered through a closer relationship between the buy side and HFT intermediaries, more liquidity could be deployed. When institutions send orders directly to HFT firms, both parties know who they’re dealing with, fair terms of engagement can be reached and institutions will likely end up paying less.
This is the logical evolution for the markets and a good supplement to the more traditional strategies of trading on exchanges and ATSs. On those venues, HFT market makers create much of the liquidity that keeps trading costs low for the buy side. It’s why we have the best markets ever for investors.
While there will always be a place for institutions to find natural block liquidity amongst themselves, in most cases they will need the help of HFT intermediaries. Judging by the news lately, it seems to be an arrangement that is working well. Perhaps that’s why the buy side isn’t buying the anti-HFT talk anymore.
TIMOTHY MASSAD, CFTC Chairman
June 3, 2015 Speech