A headline I saw in the Wall Street Journal this morning reads “Exclusive Club: No High Frequency Trading Allowed at Luminex.” That headline led me to reflect about how trading has changed in the last 25 years and the process that orders go through to be executed.
In the last 25 years, changes that began out of reforms put into place after the 1987 stock market crash have enabled anyone with an internet connection to access the market. Those changes have empowered the individual investor to make instantaneous trades without human involvement and led to the market being dominated by trades made by computer programs.
High frequency trading according to the SEC, now accounts for 50% of the trading volume in US listed equities. So why would a group of the biggest institutional money managers want to form an exclusive club where they would not have access to 50% of the market participants? The answer is that while they represent 50% of the volume they provide very little liquidity and continually extract money from each transaction. (Equity Market Structure Literature Review Part II: High Frequency Trading, March 18, 2014 sec.gov)
When an individual enters an order to execute a stock trade through an online broker, that order is routed to a market maker. The market makers are some of the biggest high frequency trading firms in the world, such as Citadel and Virtu Financial, which pay the online brokers for their order flow. Effectively, the trading firms pay the the brokerage firms to be able to take the other side of the broker’s trades. The positive effects of using this arrangement are that the investor gets an instantaneous execution and a low commission charge, but the hidden costs are significant.
Because the individual investor enters their buy and sell orders in increments of pennies, the computers can front run the orders by offering a better price in increments of sub pennies. (In other words, the computers can place their orders in increments of .001 while the individual can only enter orders priced in increments of .01.) This allows the computer programs to race from exchange to exchange or dark pool to dark pool (A dark pool is a private trading venue) looking for another order that is waiting to be executed at a better price than the individual’s order. Therefore, since the computer program has offered a better price through the extra .001 cent, they get the trade execution rather than the individual who entered the order.
The reason this represents a problem for investors is that these transactions add cost and suck liquidity from the transaction. Add these costs up over a typical trading year and you can see why the high frequency trading firms are so profitable and why the institutional investors want to avoid this transaction tax by forming their own club.
For the individual investor with the long term approach and very few transactions the high frequency trading firms have lowered the costs of investing, but for active portfolio managers they have enacted a huge tax in the form of extra costs and extracted liquidity from the market by taking over the market making function.