High Frequency Trading (HFT) is back in the headlines this week. Unlike in previous periods, it’s not trading glitches or regulatory responses that are bringing attention to the space, but the venues. In the FT’s weekend edition, the paper contained an exclusive report on the future of ICAP’s EBS FX platform, titled High-frequency traders face speed limit, authored by Stephen Foley. In an interview with EBS CEO Gil Mandelzis, FT reported that EBS may be planning to change its existing ‘first in fist out’ trading methodology with one that aggregates orders and randomizes the executions. The goal of such a move would be to place limits on high frequency traders as their orders will no longer be executed solely on the speed.
According to EBS’s CEO, Gil Mandelzis, the primary participants of the venue aren’t interested in HFT, and their existence is disruptive to platform. Mandelzis told FT “It is a technology arms race to the bottom, and a huge tax on the industry, since people are having to make significant investments in speed without any connection to their trading strategy,” said Gil Mandelzis, EBS chief executive. “Speed has little to do with why many participants come to our markets. These are serious players who come to the market to exchange risk; they do not come to race.”
At this point, it’s too early to know whether EBS will in fact apply these changes. However, they are in line with the direction the trading platform has been moving. Amidst falling volumes, EBS overhauled its trading conditions last year. A key change was the removal of 0.1 pip pricing, with minimum 0.5 pip minimum tick sizes in major currencies and full pips in less active pairs, and revised quote and fill ratio targets. At the time, curbing HFT order flow was viewed as a key goal. This time around though, EBS may be using the current article to view feedback and discussion to gauge public interest before implemented any changes.
Elsewhere, the CME Group issued a press release yesterday in response to a Wall Street Journal article that revealed loopholes HFT traders were taking advantage of. According to the report, trade execution reports are being received by members before they appear in the distributed market data. As such, traders offering orders on both the bid and ask of a product are availed the market’s direction before the general public. While the issue is a matter of split seconds, it provides HFT traders the ability to respond quicker to market changes.
On its part, the CME Group rejected the notion that the latency was consistent and stated “While there can be instances of inconsistencies with any technology, CME Group is continually making improvements to our trading platform to increase efficiencies, including variability between the time a firm or customer receives its trade confirmation and it appears on the public data feed. Out of the more than 300 million messages that come into our platform each day, there may be times when customers can experience a latency of a few milliseconds between the time they receive their trade confirmations and when that information is accessible on the public feed. However, these instances are not consistent and vary across asset classes.”
What’s Wrong With HFT
But, does it really matter that HFT traders are in the market. In the CME’s case, traders may have a head start on the market’ direction, but they are still limited to tick by tick data. Therefore, if a firm receives a note that their offer of 100.05 was filled, even though the public market data is showing an ask price of 100.00, there isn’t an arbitrage opportunity. The primary gains though for firms acting on this inside data is the ability it provides to adjust their order pricing ahead of other players. However, this is more of a technology issue than a problem with HFT order flow.
More worrisome, are arbitrage traders. As opposed to exchanges that revolves around a central order book, the OTC market consists of separate dealers pricing their own quotes to customers. As such, keen traders can profit when the market is crossed by buying from one dealer whose offer price is below the market, and selling to another dealer. This situation can occur in two ways, through latency, or simply a dealer is refreshing their quotes slowly. In regards to latency, dealers price their platforms based on a various factors such as competitor rates, internal holdings, and volatility. Therefore, a liquidity provider (LP) whose algos are refreshing slowly, could be picked off by arbitragers. Similarly, dealers that fail to adjust their spreads to volatility spikes or economic news, could be stuck with below market rates, while the rest of the market is no longer pricing similarly.
Other HFT participants include systematic traders and market makers. Systematic traders operate automatic trading strategies that are designed to enter in and out of the market quickly based on incremental changes in the market. The knock against them is that using low latency software and hardware, they are able to ‘grab’ orders ahead of the majority of participants. For dealers, they are also provide difficult order flow to hedge.
Similarly, market makers, are HFT traders that add liquidity to a venue and are offering both bids and offer orders. While they add liquidity, which leads to tighter pricing, they can present a problem to venues who can’t handle the amount of orders and cancellations they create. Additionally, as these traders aren’t classified as official market makers, they have no requirement to constantly provide pricing; thereby leading to an evaporation of their orders during different points of the day.
The market makers also cause other liquidity providers to price more aggressively; thereby decreasing margin levels. Ben Ernest-Jones, Solution Architect, Capital markets at Progress Software, whose firm produces CEP products for dynamically responding to financial date explained to Forex Magnates that “One of the major effects of HFT is to make spreads about as narrow as they will go, as any inefficiencies whatsoever are picked off immediately. That makes it harder for other organizations to get the best prices before the HFT firms do, but it also makes it harder for those other orgs to make any kind of reasonable margin. “ In terms of EBS, he added “Blocking HFT (which is probably what speed limits would do) would most likely widen spreads, increase achievable margins for the banks and incent them to do more business with the crossing networks (which is what EBS wants). This will probably slightly raise prices for everyone, but also make for a more fair market.”
For dealers, HFT order flow represents several problems; namely it can overload their platforms, causes them to be vulnerable to arbitrage, and affects other traders. The last case is due to way that liquidity providers overwhelmingly ‘price to the worst client.’ Therefore, on an unmonitored ECN where HFT is prevalent, dealers price accordingly and offer limited liquidity and wider spreads. This differs in venues that have limited HFT order flow. As such, for ECN operators, although HFT traders comes with lucrative commissions, it affects the trading network’s overall pricing and liquidity, which in turn drives away non-HFT participants.
In EBS’s case, by curbing HFT, the company is aiming to solidify its reputations as a deep liquidity venue, where participants can easily execute large sized trades that aren’t available in most networks.
Yaacov Heidingsfeld, CEO of TraderTools explained to Forex Magnates that “The FX market is not homogeneous. Different market participants trade with different motivations.” In regards to EBS, he added “EBS’s traditional customers were not speed driven, but were position driven. In batching and randomizing orders on the EBS platform, they are essentially leveling the playing field to enable them to re-attract their native customer base.” The enticing of their ‘native customer base’ is especially a concern for EBS as it has seen its market share dwindle with rivals Thomson Reuters and FXall’s platform winning business on their expense.
EBS Is Not Alone
EBS isn’t the only trading venue looking to limit HFT order flow. ParFX from ICAP interdealer rival Tradition, and newly launched LMAX Interbank are aiming to limit HFT trading on their platforms. For Tradition, ParFX, which was launched last month, represents their revamping of their FX offering to clients. The platform uses the randomized execution process which they market as offering a “unique execution logic ensuring fair trading environment for all.” While not signifying technological limits on HFT, at LMAX, the exchange lists HFT as prohibited in their ‘rulebook’ as it is stated “A bank member may not access the LMAX InterBank Service for the primary purpose of High-Frequency Trading”.
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Away from the venues, regulators have also been analyzing HFT order and have created proposals to either limit it, or create monitoring processes. For regulatory bodies, in addition to whether there is a level trading field, there is also a concern of trading glitches that can affect other participants that they want to eliminate.
Where Does HFT Go?
While it may be easy to discount high frequency trading as an opportunistic endeavor that takes advantage of market pricing at the expense of others, it is a reality. Unless the world suddenly decides to start moving backwards in terms of technology, trading systems will continue to become faster. Even if speed limits or randomization of orders are initiated, HFT traders will still exist and can be expected to migrate to other markets or innovate their methods. Therefore, it’s less of a question of whether HFT will disappear as much as where order flows are headed.
One of the recent trends among institutional liquidity is the advent of trading rooms. While, liquidity providers are pretty much universal in their acceptance of retail order flow, with HFT, they aren’t so hot about it. Creating a solution, ECNs have begun to create segregated venues that are targeted to different client types. For example, FastMatch, an FX ECN that is jointly operated by Credit Suisse as well as FXCM Pro, utilizes trading rooms. They are composed of a retail, general, and bank to bank rooms. Using the segregated system, LPs are able to price accordingly to each client type; knowing that the risks are different for each. In a way, this system resembles single dealer platforms, where a bank can create customized pricing for each of their clients. With a segregated ECN, although dealers don’t have a personal relationship with the traders, having more information about each room’s clients provides them the opportunity to price better. Similarly, CitiFX’s Tradestream liquidity offering utilizes a tiered system for handling different types of traders. (In regards to how their products compete with traditional ECNs we reached out to FXCM and CitiFX with both refusing to comment.)
On this trend, TraderTools Heidingsfeld said “What I see happening in the market, is that different trading venues will be servicing different types of flow.” In addition to the creation of multi-room ECNs, technology providers are also responding by launching customized products for the FX industry’s diverse set of trader. At Heidingsfeld’s firm, which provides liquidity aggregation solutions for traders to create their own multi-dealer platform, he explained that “at TraderTools we believe that there is no single market solution for all participants.”
Progress’s Ernest-Jones, when asked whether there is a type of HFT flow that is welcomed answered “It’s a multi-edged sword – on the one hand HFT may gobble up liquidity your algo wanted to consume, or HFT may confuse your algo with liquidity that isn’t actually real or disappears too quickly to be useful. On the other hand, it makes for a more liquid market if an HFT strategy is taking liquidity on the opposite side of the book from your algo. There is a never a straight-forward answer to the question of whether HFT is good or bad – it helps in some situations, and not others.”
He similarly believed that we are heading in the direction of customized venues as he added “This is also why some of the new venues that have appeared over the last couple years provide custom pools, where certain categories of customers are allowed, and others aren’t. It’s a recognition that some people like HFT and are happy to trade with HFT participants, while others don’t want any part of it.”
Another direction that we could see take place is the migration of HFT spot traders to exchange traded futures venues. Unlike spot FX, HFT is more prevalent in exchanges. Heidingsfeld stated that recent estimates show that between 25-30% of FX trading is HFT. This contrasts with US FX futures exchanges wheree according to the Tabb Group, as mentioned in the WSJ’s article, HFT accounts for 61% of volumes. As such, with the order flow much more common in futures, disgruntled spot traders may just adapt their strategies for futures.
HFT Led ECNs?
Due to the lucrative margins in retail FX market making, there has been an entry of trading firms searching for opportunities to provide services to the industry. Their presence is primary as non-dealer market makers providing liquidity to retail oriented offerings such as Hotspot FX’s Wholesale Liquidity product or secondary prime brokers.
With their presence as market makers already in the FX industry, perhaps we will also see HFT players combine resources and create their own ECNs. With their knowledge of cutting edge technology and low latency trading, they could theoretically provide a solution that could handle the needs of fellow HFT traders. Throwing the idea off of several institutional insiders, they believed that although such a venue could become a competitor for existing products geared towards retail order flow, they would run into the same problems with HFT traders that dealers currently experience.
Taking it further, Heidingsfeld also pointed out structural problems that an HFT driven ECN would experience, as he said “HFT market makers have limited credit and therefore are limited in the quantity of liquidity they can offer.” He added “While banks are “committed” to making prices for their customers 24/5 (local time), HFTs are not and have shown that there are times when, for whatever reason, their algo model stops making prices, either in (a) particular pair(s) or over a period of time. There simply wouldn’t be sufficient flow to generate critical mass.”
ICAP & EBS
Moving back to ICAP and EBS. EBS is without a doubt in a transition mode. Beyond just changes in its trading conditions, the firm has also made plans to launch EBS Direct. The unit, which is currently still in testing, is a relationship based platform that will operate alongside EBS’s ECN product (recently renamed EBS Market). Often, when working directly with LPs and creating a relationship within, traders are able to source more competitive pricing than what the same dealers offer on public ECNs. As such, having the ability to combine both ECN and relationship pricing within one trading platform provides traders a seamless method to execute best pricing. FXall, which was created by co-launched by a group of banks and later sold to Thomon Reuters, and combines both ECN and relationship pricing within one system, was able to reach record volumes on its platform in 2012, even as the industry suffered overall declines. Adding to the EBS Direct initiative, ICAP has also acquired liquidity optimization firm ClientKnowledge, to assist with customer implementation of combining both public and relationship based pricing.
Beyond EBS, ICAP has also been expanding its FX related products. One such example was its2007 purchase of post-trade monitoring firm Traiana. Since acquiring the firm, Traiana has expanded Harmony-NetLink and CreditLink products to more than just connect Prime Brokers and LPs, but also to ECNs. Additionally, they have been making inroads in launching pre-trade credit monitoring products. Recently, ICAP sold a 12% stake in the division to seven of its customers. For customers, aligning multiple services of the FX trading process within one roof provides a streamlined product. ICAP can also leverage the diversity for cross selling opportunities.
As an interdealer, ICAP is making the definitive move to service more of the FX market. While doing this, they are also strengthening their ties with their dealer customers. This has been done by limiting HFT order flow within EBC, launching EBS Direct to provide easy access for traders to trade with their LP partners, and through the partial sale of Traiana. As such, ICAP can be described as smartly tying its fate with that of its customers; thereby offering incentives to ICAP partners to continue sending them business.
With that in place, the question is what is the next step for them to take in FX? While no more than a conjecture, perhaps we ICAP will move to leverage the existing bank to bank network in place within Traiana and launch its own settlement service. Owned by its members, CLS Bank currently settles the lion’s share of FX volumes, with over $2 trillion a day (using BIS accounting) going through the system. However, for each of those transactions fees are collected by CLS. Minimizing these fees, post trade firms like Traiana are using trade compression methodology to reduce the amount of transactions sent to CLS Bank; thereby decreasing costs. As such, if ICAP can further develop a feature to reduce settlement fees, it could theoretically see an increase of customer uptake on its systems. Increasing revenues of course, is the whole reason they are debating whether to curb HFT trading to begin with.