“High-speed trading hurts ETFs”, Paul Britt wrote in a recent IndexUniverse.eu column.
“Maybe someone can explain to me how a trading system where virtually all the orders are cancelled helps capital markets or investors,” Paul says.
“Key liquidity measures like bid/ask spreads and depth of book depend on order information. With high-speed trading, almost all of that information is false.”
Well, Paul, I will give it a try. Since you use exchange-traded funds as an example, I will follow suit and focus on ETFs. I think that high-frequency trading (HFT) actually benefits ETFs, and that without it there would be no properly functioning market.
Imagine a world where there is a ban on HFT and therefore also on market makers (who are all high-frequency traders). How would price discovery take place? It would depend on end-investors posting ‘real’ orders to buy and sell ETFs.
But how would that work for a newly issued ETF with no assets in it? Investors could put in bids if they wanted to buy the ETF but there might be no bids in the market. There would also be no investors holding any ETFs and therefore no sell orders. We would end up with an empty order book.
Could the ETF issuer enter sell orders to meet the buyer’s demand? That would involve the issuer getting a trading license, posting bids and offers on exchange, and hedging positions until units can be created and redeemed. Wait a minute, that’s exactly what a market maker does, but that’s illegal!
I think I’ve made the point that we actually need market makers to have a functioning ETF market.
But let’s investigate where all these so-called ‘fake’ orders might be coming from. Let’s consider a newly issued ETF, say on the S&P 500 index. The ETF issuer hires a market maker to quote a five basis-point (0.05%) spread in the fund.
Assume that the mid price of the S&P 500 future is 1200 and the ETF market maker calculates US$100 as the mid-point indicative net asset value (iNAV) of his fund. He then quotes a two-way screen price of $99.98—$100.03 in the ETF, offering to trade in 10,000 shares on each side of the quote. These quoted prices are fully executable for any counterparty and are not in any sense ‘fake’ orders.
What happens if the S&P 500 future then moves to 1202.5 (roughly 0.2% higher)? The new ETF iNAV would be US$100.2 and logically the market maker would quote something like $100.18—$100.23 as his new bid-offer spread. If his quote remained at $99.98—$100.03 another market participant could have bought ETFs at the market-maker’s offer price of $100.03 and the market maker would have a loss of around $0.17. Clearly that’s not an option, so he will adjust his quote.
But, wait a minute, if the first quote didn’t result in a trade it should be considered a fake order! And as the S&P 500 index moves around during the day the market maker will end up posting a whole series of such ‘fake’ quotes. Quick—call the regulators!
We’ve already shown that ETFs need market makers to generate liquidity when starting. But what about liquid funds that already have substantial assets under management? As ETF trading volume begets more volume, more and more firms will join the market making book to trade against that coveted investor order flow. Some will be more successful than others. But it’s easy to see that, in most cases, the market maker quotes will far outnumber the actual investor trades. Does this mean that the market makers are manipulating the market? No! All of their quotes are executable, and most of them actually want to see their quotes get filled!
There is a reason why many exchanges and regulators see no reason to ban HFT and/or market-makers as a whole. They fulfil a vital role in creating liquidity and, apart from capacity issues at the exchanges, there is no reason to set limits on order-to-trade ratios.
Of course there will always be people out there who will try to manipulate markets, but HFT as a concept has nothing to do with that. Manipulative strategies can be both high- and low-frequency in nature. To quote the NRA, “guns don’t kill people, people kill people” (apologies for comparing HFT to guns, but you get the point). HFT can be used for good and bad purposes and it is up to the regulators to police it. But please let’s stop talking about fake orders.
Bart Lijnse is Managing Director of Nyenburgh, an ETF market maker