A growing number of investment professionals are saying less-than-flattering things about high-frequency trading. Proponents of this controversial practice contend it adds liquidity to the market and provides other benefits to investors. But not everybody is convinced.

One money manager, for instance, Southeastern Asset Management, an advisor to $34 billion in client accounts, including Longleaf Partners Funds, asserts that high-frequency trading allows short-term professional traders to insert themselves between long-term buyers and sellers in costly ways.

"This intermediation conservatively results in $20 billion per year in execution costs and untold billions in opportunity costs for investors," Southeastern wrote to the Securities and Exchange Commission after the agency asked for public comments on market structure. Specifically, the SEC asked market participants whether high-frequency trading allows "a substantial transfer of wealth from the individuals represented by institutional investors to proprietary trading firms."

TABB Group, a New York consulting firm, estimates high-frequency trading now accounts for 70% of daily total trades and up to 61% of daily U.S. share volume.

High-frequency trading firms can operate as stand-alone proprietary trading firms, as proprietary trading desks at multi-service broker-dealers or as hedge funds. They might trade stocks, index futures, exchange-traded funds or some combination of these and other asset classes. The common element is that they can execute massive numbers of small long or short orders in microseconds using high-speed computers and sophisticated algorithms in hopes of making a small profit on each.

The Benefits: Real Or Illusory?
Advocates claim high-frequency trading benefits all market participants, not just the traders, though the actual evidence is scant. It supposedly improves prices by narrowing bid-ask spreads, and spreads have indeed gotten thinner on many large-cap stocks. But the contribution of fast-trading to that trend is debatable, market observers say. Even if the traders are shrinking spreads, the SEC says the excessive volatility in the market often attributed to them may harm long-term investors because the short-term price movements can overwhelm the spread many times.

High-frequency trading also lowers execution costs for market participants, its advocates say, and yes, commissions, like spreads, have declined. But the CFA Institute told the SEC it believes this trading "may prove costly to the average investor who invests through large mutual funds."

"Given that HFT transactions typically execute small orders," the institute wrote, "it follows that there are higher and/or disproportionate associated costs to longer-term investment funds that must pay additional trading fees to execute many small trades to deal with large positions."

Others argue that the high volume of cancel and replace orders increases trading overhead for market participants, who must pay higher technology costs to process all the quote data.

Liquidity is another purported benefit of the practice. But high-frequency traders often display quotes only to yank them split seconds later, before others can react. Thus the liquidity these traders tout is "not real and accessible," Southeastern asserts. Such liquidity can evaporate at any time, as it did on May 6-the day of the so-called "flash crash"-when high-frequency traders halted their trading and volume and prices fluctuated wildly. Consequently, critics argue that high-frequency trading arbitrarily inflates and deflates asset prices. The traders "will trade when it is beneficial for them. They are for-profit enterprises who are not altruistically motivated," Southeastern told the SEC.

Intermediation Winners And Losers
"High-frequency trading systems are like vacuum cleaners. They suck nickels and dimes off the market floor all day long," said Richard Gardner, the CEO of Scottsdale, Ariz., trading software developer Modulus Financial Engineering, in a press release. 

Perhaps the most controversial aspect of high-frequency trading is that exchanges and trading centers can give traders direct data feeds and place the traders' servers physically close to the trading center's matching engine (a practice known as co-location). The combination of the two allows the high-frequency traders to quickly jump between buyers and sellers to scavenge modest per-share profits on large numbers of trades. In other words, their computers see other investors' orders before they're displayed to the market, then trade ahead.

The direct feeds contain significantly more than just the price and size information shown in the consolidated feed the rest of the market sees. The extra data includes the time stamp, the side (buy or sell), revisions, reserve orders, linked executions and more, according to a May 2010 white paper by Themis Trading, a New Jersey-based agency brokerage that trades for institutional clients and does no proprietary trading. The firm's co-head of equity trading, Joe Saluzzi, says Themis devotes a fair amount of time researching high-frequency trading "to protect its institutional clients from getting ripped off."

What really bothers him is information that allows high-frequency traders to ascertain an investor's accumulated volume in a position. "Buried deep inside these enhanced data feeds are little order IDs that attach to every order, and they give away information that institutions thought was hidden," says Saluzzi. While the IDs don't reveal the order originator's identity, they do show the number of shares a particular investor has accumulated in a certain time period.

This information allows high-frequency trading algorithms to predict price movements with virtual certainty, then profitably insert themselves between buyers and sellers and drive up investors' costs, Saluzzi argues. "The trade where you paid $27 a share, you probably should have paid $26.80 because the high-frequency trading guys were able to spot you and take advantage of you all day long." And if you were a disciplined buyer who wanted the stock at $26.80 and not a penny more, you lost an opportunity to buy.
The direct data feeds almost always reach their subscribers before the consolidated data feeds reach everyone else. Co-location puts high-frequency traders in an even better position (due to lower latency, or the amount of time it takes data to travel from the trader's terminal to the matching engine) to take advantage of the information in the private data feeds and trade ahead of other investors' orders.

"A fraction of a second is a huge advantage," Saluzzi says. "It's enough time to recalculate the national best bid and offer and take advantage of an incoming order."

The Investment Adviser Association, a trade group in Washington, D.C., says, "Investment managers are concerned that publicly revealing their significant trading interest may lead to professional traders attempting to take advantage of their investment strategy."
As far as Southeastern Asset Management is concerned, "Combining the use of direct data feeds with co-location services gives HFTs an unfair and inappropriate opportunity to detect and disadvantage long-term investors." Some call this "legalized front-running."
But Southeastern makes another important point about high-frequency trading, one that goes to the very heart of the investment profession's raison d'être. The firm said in its comments to the SEC that giving high-frequency traders a pre-public view of detailed order information is tantamount to theft of its intellectual property.

After all, an advisory firm's trading decisions represent the aggregate result of its proprietary research and analysis. "The property rights of creators of intellectual capital are being systematically and openly ignored by the exchanges and certain market participants. The order originator's hard work, ingenuity and prospective returns are being taken and sold by those who did not create it," Southeastern said.

Whose Data Is It?
As for who owns the information in the direct data feeds-order originators such as Southeastern or the exchanges-the law may not be entirely clear. Between 1905 and 1926, several U.S. Supreme Court cases examined the legal interest that an exchange had in its quotations. Comparing the quotations to trade secrets, the court said that the exchanges had a proprietary interest because of the work they put into assembling them. As the owners of the quotations, the exchanges were therefore free to sell, or refuse to sell, the quotations to anyone they chose.

But a lot has changed since the early 20th century. For instance, a direct data feed contains more than just quotations. A court could consider that fact pattern sufficiently different to warrant a different outcome today.

Moreover, the court only discussed the exchange's proprietary interests. Nothing was said about the order originator's proprietary interests, notes Andy McCarroll, Southeastern Asset Management's vice president and general counsel. "Our view would be that the order originator should be able to control how the order is distributed and put into the public domain until the point in time when the exchanges have a legitimate interest in putting out transaction information for price discovery purposes."

Southeastern believes the issue of ownership of order information needs to be addressed. "The right forum, right now, is this public debate about market structure," McCarroll says.

Few suggest an outright ban on high-frequency trading. Many, like Themis' Saluzzi, just want the SEC to establish some rules of the road. He thinks that unless such trading is appropriately reined in, "You'll see more flash crashes, less confidence in the equity market and more distorted valuations," he predicts.