Over the last few years, a number of exchanges and dark pools emerged claiming that their businesses will exclude high-frequency traders (HFTs) detrimental to institutional investors. Almost invariably, the HFTs in question happened to be the so-called Aggressive HFTs: HFTs that execute mostly using market orders and have been shown to erode liquidity, causing short-term volatility in the process. While the idea of excluding aggressive HFTs may be appealing to investors, the realities of modern microstructure preclude this from happening, as this article discusses. As a result, most of today’s exchanges in the United States have a similar proportion of aggressive HFTs by volume of executed trades.
There has been something like an explosion in trading venues. Presently there are thirteen or more exchanges, and some additional fifty alternative trading venues that include dark pools and other entities. With such a proliferation of competing trading venues, these entities need to differentiate themselves to attract business, so it may seem only natural that some of them can decide to exclude specific categories of investors. In fact, most trading venues can and do exclude specific categories of clients (for instance, most dark pools exclude investors not reaching specific capitalization criteria). However, as this article shows, excluding HFTs is not at all straightforward and, most often, not feasible.
The key reason for this is modern regulation, and, specifically, Regulation National Market Systems (Reg NMS) adopted in 2005. Reg NMS introduced the concept of the National Best Bid/Offer (NBBO), and mandated that all trading venues only execute at the prevailing NBBO. To ensure that NBBO is timely and that every trading venue is aware of the NBBO, the U.S. government has created a system for collecting and then disseminating best bids and offers available across all exchanges throughout the trading day. The system, known as Securities Information Processor (SIP), collects the real-time data from all the trading venues, aggregates it and then redistributes the data back to the trading venue participants. As of the time this article was written, the government guaranteed the round-trip aggregation and redistribution time of best quotes of at most 500 milliseconds (one half of one second).
NBBO quotes are an important innovation to ensure market fairness. To understand why, we need to examine the ways in which trades are made on trading venues, in equities and other asset classes. Every trade involves two participants, a buyer and a seller. Both parties have choices to place the order with market orders or with limit orders (other, more complicated orders exist as well, but those are generally constructed using limit and market orders, and tend to cost more than the basic market or limit execution). A limit order is an instruction to execute the order intraday at a specific or better price, without consideration of time. Limit orders are stored in a now-electronic “limit order book” – a record of all limit orders, their executions and cancellations. A limit order can be matched with an opposing market order (e.g., a limit sell order can be matched with a market buy order) or with an opposing limit order that “crosses” the given limit order’s price (a limit buy order at $80.00 can be matched with a limit sell order at $79.00). A market order, on the other hand, is a directive to execute the order immediately at the best available limit order of the opposing side.
Anyway, following the NBBO rule of Reg NMS, exchanges and other trading venues may only execute a market order on their exchange whenever the exchange has limit orders in their limit order book that are at least as good as the National Best Bid/Offer. In other words, an exchange can execute a market buy order only when the exchange’s limit order book has a limit sell order the price of which is lower or equal to the best offer across all trading venues in the United States of America. When the exchange fails to attract limit order traders with NBBO, the exchange is required by law to route the order to another exchange that may or may not have NBBO quotes. Of course, the order routing happens electronically, and very fast. The order routing is not free, however. Instead, trading venues may charge quite a bit for routing orders to competitors. For example, New York Stock Exchange (NYSE) charged $0.0030 per share to route customer orders to other exchanges as of August 31, 2015 (see).
As a result, most market orders, whether high-frequency or low-frequency, are required by law to be passed on to another exchange when the given exchange cannot fill according to NBBO . Furthermore, the market orders are passed from one exchange to another quickly and anonymously, blending HFTs with billion-dollar pension funds as well as $30,000 retail investors. If customers of a trading venue like IEX, for instance, place a limit order that coincides with NBBO and another exchanges has routed them a market order, the IEX exchange will 1) have no way of knowing that the market order they just received was generated by an HFT, and 2) they will execute the order and collect execution fees. The result is stark: most exchanges and trading venues are likely to register an equivalent proportion of aggressive HFTs in their market order flow. AbleMarkets data analysis of on various financial exchanges confirms this finding.
Steve Krawciw is CEO of AbleMarkets.com. Irene Aldridge is Managing Director of Able Alpha Trading, LTD., and and author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems (2nd edition, Wiley, 2013).