Over the last few weeks we've seen plenty of coverage on how high-frequency traders are suddenly struggling in the low volume environment that's currently afflicting the equity markets.
The closure of Eladian Partners last week certainly underscored the challenge now facing high-frequency traders, who in addition to grappling with the impact of a fourth straight year of shrinking domestic equity trading volumes, now also find themselves facing severe regulatory hurdles overseas and calls for more oversight by authorities here in the U.S.
Despite these challenges, however, industry consultant Haim Bodek contends that the U.S. equity market structure is still heavily tilted in favor of high-frequency traders, which has ultimately made it more challenging for financial institutions to source liquidity.
In a series of articles recently published on TabbForum , Bodek argues that the exchanges are also doing their part to ensure that high-frequency traders have a leg up in the marketplace, something that came about following the passage of Regulation NMS – Rule 610 in particular. The rule, which banned locked markets, became something that both exchanges and HFTs could exploit.
HFT is about being first in the queue, period. That is an HFT's primary alpha. The implementation of REG NMS in 2007 changed the mechanisms for achieving queue position in a price-time priority market. This fundamentally changed trading strategies and exchange matching practices. By banning locked markets, REG NMS constrained the mechanisms through which a price movement occurred in the U.S. market. Thus, Rule 610 defines precisely the conditions in which an HFT can achieve a superior place in the queue (i.e., when an order would not lock an away market).
Going a step further, Bodek says this rule resulted in HFTs deploying so-called "spam and cancel" strategies whose aim is to get to the top of the order queue on a price move. Once these strategies began to dominate top-of-book trading activities, the exchanges learned they could generate vast amounts of orders and fees.
So Bodek says they created new order types to help make sure high-frequency traders had a place at the top of the queue.
Over the period from 2007 to 2012, the introduction of special order types that "hide and light" proceeded quite quickly, as exchanges matched each other feature for feature with intense competition for HFT order flow. NASDAQ released Price to Comply. BATS released Display-Price Sliding. NYSE ARCA released Post No Preference Blind. Direct Edge released Hide Not Slide. Such order types were repeatedly modified, usually to address specific microstructure nuances that primarily impacted HFT scalping strategies. For example, certain exchanges eventually modified the feature set of order types that "hide and light" to define the specific conditions in which such orders would interact with midpoint liquidity.
And how did all this impact institutions? "For institutions using default exchange modes that subjected their orders to traditional price-sliding, they remained a tick back at the back of the queue away from the trading action," Bodek writes.