High frequency traders a threat to institutional investors?

According to a white paper by New Jersey-based Themis Trading, HFTs are currently dominating the equity market (generating as much as 70% of the volume) by executing billions of trades a day. Such programs make money either by making miniscule profits many times over or similar amounts of per share liquidity rebates provided by the exchanges. The end result, according to the report, is an extremely profitable business.

While many institutional investors would assume that such transactions would provide a net benefit due to the liquidity created, Themis Trading warns of three potential problems HFTs might present.

1. HFTs provide low quality liquidity.
“In the old days, when NYSE specialists or NASDAQ market makers added liquidity, they were required to maintain a fair and orderly market, and to post a quote that was part of the National Best Bid and offer a minimum percentage of time,” write the report’s authors. “HFTs have no such requirements. They have no minimum shares to provide nor do they have a minimum quote time. And they could turn off their liquidity at any time.”

2. HFT volume can generate false trading signals.
By buying or selling at such a tremendous rate, HFTs can create volatility in the market that can cause other investors to buy at a higher price—or sell at a lower price—than they would otherwise.

“A spike can attract momentum investors, further exaggerating price moves,” says the report. Such a spike might lead options traders to build positions which could attract risk arbitrage traders who believe there’s potential news that could affect the stock.

3. HFT computer servers are faster than other trading systems.
The speed at which HFT servers operate allow them to beat out institutional or retail orders, causing them to pay more or sell for less than they should have for a stock.

The white paper also wades into possible scenarios that could be created by HFTs. Should a regulation such as the “uptick rule” (which prohibits short selling of securities except on an uptick) be enacted, volumes could implode and stocks that were previously highly liquid could become extremely illiquid.

Another concern involves “rogue” algorithms entering the market. The paper explains that many HFTs are hedge funds that enter their orders through a “sponsored access” arrangement with a broker. Because such funds demand the utmost in transaction speed, many of these arrangements do not have any pre-trade risk controls. The danger, explains Themis Trading, lies in the lack of human control once an order is placed into the system.

“Due to the fully electronic nature of the equity markets today, one keypunch error could wreak havoc,” says the paper. “Nothing would be able to stop a market-destroying order once the button was pressed.”

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