Professional traders, HFT technology and the value provided to investors

As lawmakers continue to hold hearings on Capitol Hill assessing the current state of the marketplace and investor confidence, they should be aware that our financial markets have always had professional traders who worked as intermediaries, ensuring customers could find a good price when they needed to trade. 

As long as there have been markets, professional traders have been there acting as short-term intermediaries, smoothing out price fluctuations by buying when there are more investors looking to sell and selling when more investors are looking to buy. These traders do not provide this service out of altruistic motives; they profit from accurate pricing, short-term predictions, and careful risk management.   Properly managing their inventory and efficiently interacting with the market is key, if intermediaries are not able to find the right price where natural supply and demand are balanced, they will lose money as the market moves against them. 

Remember floor traders?

Before the recent advances in computer and telecommunications technologies, professional traders had to be located on the floor of an exchange in order to get access to the level of market information they needed to accurately price the market.  

On the floor of the New York Stock Exchange, these professional traders were called specialists. On the floors of futures exchanges they wore colorful jackets and were called locals.  In the early days of NASDAQ, these traders worked primarily for big banks. 

The big banks acting as NASDAQ market makers used to make many billions of dollars a year.   The specialist trading firms on the New York Stock Exchange used to have multi-billion dollar market capitalizations.  The chairman of the New York Stock Exchange even made over $180 million in just one year.   

Today’s modern investor and the democratization of markets

But then advances in telecom and computer technology began to alter the market structure.

Information about what orders were in the market was no longer limited to just the traders occupying the floor of the exchange.   Now, anyone who invested in a data line and a computer could see all the details of what orders were in the market.

A liberation of information had arrived and a new type of trader now aided the marketplace.   Professional trading firms using high frequency trading technology were now able to act as intermediaries along with the old school floor traders.  

This new competition introduced by professional trading firms and high frequency traders has led to markets becoming much more efficient while trading costs have been lowered for investors. 

According to Gus Sauter, previously Vanguard’s Chief Investment Officer, transaction costs in U.S. equities have been cut by about 60 percent in the last 15 years.

The savings reaped by individual investors from these reduced transaction costs have been significant.   According to Sauter, “reduced transaction costs have enabled a mutual fund investor to reasonably expect an investment balance that is perhaps 30 percent higher than what they could have expected only a decade ago.”

So if markets are more efficient, and investors of all types find it cheaper to trade, why does high frequency trading continue to be demonized by critics? According to Cliff Asnes, head of money manager AQR, it’s in part because innovators have challenged the old guard.  As he recounted in Financial Analysts Journal: “Some market participants who, before HFT, used to provide liquidity in more traditional ways are simply annoyed that their business has been taken by those who provide it more cheaply.”

Adapting and innovating for investors

The migration to modern electronic markets has not been pain-free.  We have seen examples of run away computerized trading and data distribution issues that highlight that new types of problems can occur in electronic markets.  And as is the case with all forms and styles of trading there are those less savory who look to take advantage. We all need to be diligent about prevention and work to insure that these problems are corrected and bad actors removed.

But as we confront the challenges and opportunities that modern technologies offer to financial markets, we need to remember that the new market structures and high frequency trading have produced efficient markets that provide fair prices to investors.  

The markets are not broken but there are issues we can work together to fix. As regulators such as the SEC look to implement data-driven reviews to strengthen U.S. market structure, we need to keep in mind that we are on the right track. High frequency trading benefits investors. Certainly, we can fix the problems that exist, but we also need to preserve the benefits that high frequency trading provides. 

Nabicht is senior adviser to the Modern Markets Initiative (MMI), an advocacy organization of professional trading firms using high frequency trading technology. He was previously an executive vice president and Chief Technology Officer at Allston Trading.

More in Technology

Tech visas in line with American values

Read more »