By Jason Zweig (WSJ)
They’re mad as hell, and they’re not going to take it anymore.
On Oct. 4, mutual-fund executives will convene in Washington at the Investment Company Institute, the trade association for fund managers. People familiar with the situation say a few attendees are determined to push for a plan to restrict high-frequency trading, the rapid market activity that lately has caught the attention of investors large and small.
Using powerful computers and data feeds, high-frequency trading firms typically hold stocks a few minutes and sometimes only a few seconds at a time, churning roughly half of total stock-market volume. Whenever you—and your mutual fund or pension plan—buy or sell a stock, one of these fast-trading firms is likely to be on the other side of the trade.
The problem? While some fund leaders have praised high-frequency trading for making markets more efficient, others contend that the profits earned by fast traders may come partly at the expense of ordinary investors.
Mutual funds and other giant investors are often forced buyers and sellers. When money comes in they must buy stocks; when it goes out they must sell. Their typical buy or sell order is roughly 185,000 shares. Yet the average trade size on U.S. exchanges is only about 100 to 300 shares.
So institutions trade in dribs and drabs. A giant buy order would push up a stock; a huge sell order would knock it down. “Would you leave $100 in cash on the street corner and hope nobody takes it, or would you hide it in your pocket?” asks Andrew Brooks, head of U.S. equity trading at T. Rowe Price. “Information about our order flow is valuable, and we need to protect it.”
Any institutional order for a couple hundred shares can have thousands or even millions of shares behind it. A fast trader that can infer which orders were placed by a big institution gains an insight into how stock prices may be about to change. Whoever gets there first stands to make a tiny profit on each of those trades.
Direct data feeds supplied to fast traders by several major exchanges have customarily included an “order ID”—a kind of tag that, according to several traders, may assist a fast trader in deducing whether a large institution lurks behind a small order. Starting Oct. 4, the NYSE Arca exchange will give customers the option of having these IDs removed from its direct data feeds on orders they don’t want displayed to the whole market.
Traders say the absence of the ID may itself alert rapid traders to the presence of a large, hidden order. “Without the order ID, we don’t think anyone could map the order to any other information to divine that it is part of something larger,” responds Ray Pellecchia, an NYSE Euronext spokesman.
Or consider a type of trading order called a “partial post only at limit.” Here, if a fast trader’s small buy order is rejected instead of executed, the firm can deduce that a large block of shares may lie hidden in reserve, poised to sell at a given price. Thus a trader may be able to get information without executing the trade. Clever use of this order type can increase the trader’s odds of being in the right place at the right time—capturing a splinter-thin, lightning-fast profit before the institution can move.
Chris Isaacson, chief operating officer at BATS Exchange, the third-largest U.S. stock market, downplays such concerns. “This order type is rarely used and would be very complex to implement for the purpose of detecting a large order on the other side,” he says. Such a trader “would have to be willing to take considerable risk.”
“There are aspects of the market structure which give [fast traders] an unfair advantage,” says Manoj Narang, chief executive of Tradeworx, a high-frequency firm in Red Bank, N.J., that trades about 200,000 times a day, turning over roughly 50 million shares. “And those should be changed.”
One such practice: 1,000 shares are offered for sale at $20, and someone wants to buy 2,000 shares at $20. The buyer should be able to purchase the 1,000 shares immediately, while the other 1,000 shares should instantly show as the new “best bid” at $20.
Instead, says Mr. Narang, while the 1,000-share purchase goes through right away, the open order to buy another 1,000 is displayed to the entire market at a slight delay. Traders that can place orders faster can jump ahead, putting them in the best position to buy more shares at $20, in hopes of reselling them at a higher price. Mr. Narang says this occurs “at least tens of thousands of times per day.”
Whom should the market be designed to serve: Short-term traders or long-term investors? Is it serving both fairly?