LET'S DEBATE HFT, DARK POOLS AND MARKET INTEGRITY
- BY Per Loven
The past five years have seen the transformation of the equity markets, driven primarily by globalisation, technological innovation and supportive regulatory regimes around the world.
In practical terms this has meant increased competition, greater cross-border capital flows and tighter spreads. On the surface this change appears to be good news for institutional investors responsible for investing the assets of millions of savers, but parallel developments risk creating unprecedented distortion in the equity markets. Although several factors can be considered, the role of high-frequency trading has been pivotal to this distortion, with long-term negative implications.
While not all high-frequency trading is detrimental to the market, a large portion of strategies deployed, such as momentum-type arbitrage, are simply exploiting supply-demand imbalances from institutional orders, in order to realise profit from tiny price differences with a time horizon of milliseconds.
Many times in this debate, market participants and other organisations have highlighted the dangers of this growing gap between trading driven by the desire for speculative profit based on such price differences, and trading based on economic and research fundamentals.
What makes these developments more concerning is the possibility that institutional trading activity, whose purpose is to deliver on an investment strategy based on long-term fundamentals, is in fact suffering at the hands of high-frequency trading, which disconnects the relationship between company performance and share price.
If this behaviour continues to spread, the risk is that equity markets will fail their traditional customers institutional investors and, in turn, listed companies that rely on real liquidity to fund long-term growth and deliver shareholder value.
The concept of liquidity is an important one, especially since it is often confused with volumes. High-frequency trading may add volume to the markets, but volumes do not equal liquidity. The markets need a useful definition of these two concepts. We would agree with the definition of liquidity being the ability of market participants to buy and sell with minimum market impact; volumes being the number and monetary value of transactions realised, regardless of the price impact of those transactions. Nowhere is this dichotomy more obvious than in the equity markets.
In fact, listed companies that access the markets to fund long-term growth and to generate shareholder returns, cannot rely on artificial liquidity that disappears in milliseconds.
Technology and speed are not to blame the market has simply fulfilled its technological potential. That said, by trying to address the impact of high-frequency trading, such as limiting the number of messages they send to exchanges or imposing resting orders, we risk focusing on the wrong variable. You cannot measure the impact of high-frequency trading by the number of messages sent (which eventually convert into volumes not liquidity). The real impact can be seen in their motivation and intent, which is to profit from minimal price changes, thus distorting liquidity in the equity markets and, in turn, deterring much-needed investment in European equities.
Institutional investors are by no means oblivious to this change. They have shown resilience to the changing face of liquidity by adapting their execution strategies accordingly. As an example, for larger orders, institutions may often choose to trade away from the public, or lit, markets, in specific institutional venues such as Liquidnet, to minimise the impact and interference from high-frequency trading.
Such venues are often referred to as dark pools, a label describing various non-displayed trading venues. It is important to note that not all dark pools are the same, and their motives matter just as much as those of high-frequency trading firms.
Market participants generally agree on there being a trade-off between a non-displayed environment and preserving fairness and price formation for all. Nowhere is this trade-off seen as more justified than for those dark pools focusing on larger block orders, thereby minimising market impact and providing unique value.
We are fast moving into a stage where trading volumes are wrongly being cited as an indicator of the health of the markets. This is bad news for market quality. Its time to separate fact from fiction on both high-frequency trading and dark pools, and bring much-needed integrity to the debate.
