In Defense of the High Frequency Trading Community

In the wake of the global financial market’s dramatic collapse, the blame game has started. Most recently, the focus has turned to hedge funds, private equity firms, venture capitalists, proprietary trading firms, and the regulators themselves. No one is safe as what appears to be a never-ending hunt for the perfect scapegoat continues.

Wall Street is already anticipating an avalanche of regulations. Treasury Secretary Timothy Geithner’s outline of wide-ranging reforms across financial services seems to confirm some of the industry concerns. In light of the highly publicized Madoff scandal, the hedge fund industry appears to be a prime target for additional regulation. Various potential regulations, including the reinstatement of the uptick rule and transaction tax directly threaten the business model of the high frequency trading community.

A new report from Aite Group, entitled, High Frequency Trading: A Critical Ingredient in Today's Trading Market, examines the growth of the high frequency trading community and details its overall impact in the marketplace. It argues that the failure to include the high frequency community in the regulatory dialogue can have a potentially devastating impact on the overall growth of global markets.

In recent years, growth of alternative electronic trading venues has been driven by a multitude of factors: the introduction of decimalization; the adoption of FIX as the main protocol for electronic communication; the availability of technology for developing market infrastructure conducive for electronic trading; the rapid adoption of electronic trading; the adoption of algorithmic trading; and the availability of co-location services.

All of these factors have also created a fertile ground for the exponential growth of the high frequency trading community. The high frequency trading community, in turn, has added significantly to the increased volume in the market. It has also taken part in improving market quality, as defined by increased liquidity and tighter spreads.

In today’s highly electronic trading environment, high frequency trading firms play the role of liquidity providers, very much like the traditional market makers and specialists of the past, just without the perception of conflict of interest and information advantage. In other words, someone has to be paid to provide liquidity into the market, and the high frequency trading community represents the next evolutionary group to do so.

However, many in the market still view the high frequency trading community as potentially harmful to the overall development of the marketplace. While even the harshest critic would agree that the high frequency crowd has played an important role in increasing overall trade volume, doubts exist in terms of value of liquidity provided by actively trading firms that move in and out of positions in microseconds.

Now, in an era of increasing regulation, industry buy-in is a must, and careful considerations and input from all key segments of the financial services industry will be critical in stabilizing the marketplace. Failure to do so may lead to unintended consequences that could cripple the marketplace, such as a short-selling ban and the proposed transaction tax potentially leading to drastic decline in overall trading volume.

Both the regulators and rest of the market participants must spend the necessary time and effort to ensure that the interests of the high frequency trading community can be incorporated into any future changes that may threaten their business model. Given the level of influence the high frequency trading community current has in financial services industry, any regulation developed without their participation is doomed to fail.

In the past, the market faced many challenges, including lack of market transparency, unreliable price discovery mechanism, wider spreads, and skewed market forces that favor specific firms with an unfair information advantage. High frequency trading firms have addressed all of these issues through the development of smart trading models and innovative technology, and have essentially leveled the playing field for everyone in the marketplace. In the end, high frequency trading firms should be viewed as a by-product of market evolution that have taken up the critical role of providing much needed liquidity into global financial markets.

About the Author Sang Lee is a managing partner with Aite Group, LLC and the author of a recent research report titled, High Frequency Trading: A Critical Ingredient in Today's Trading Market. In it, he examines the growth of the high frequency trading community, and details its overall impact in the marketplace. Based on trading data and interviews with key market participants the report also reveals that a failure to include the high frequency community in any regulatory dialogue could have a potentially devastating impact on the overall growth of global markets.