Market participants speaking at a June 2 public meeting at the Securities and Exchange Commission disagreed over whether high-frequency trading helps or harms the U.S. equity markets. Several agency brokers and institutional investors complained that high-speed trading is making the U.S. equity markets less stable and urged the SEC to restrict “predatory” trading practices. Their arguments were countered, however, by other participants in the discussion, including other institutional investors as well as several high-frequency trading firms. These participants emphasized that high-frequency trading benefits the equity markets by increasing liquidity and reducing trading costs, and they urged the SEC to proceed with caution before altering the existing regulatory framework.

High-frequency trading was only one of many issues discussed during the day-long roundtable discussion, which was organized by the SEC as part of its comprehensive review of equity market structure. Earlier this year the agency issued a concept release asking for comment by April 21 on a wide range of issues related to market structure and several hundred comment letters have been received to date.

SEC commissioners and staff asked a number of questions during the discussion but did not offer any conclusions on what policies may emerge from the market structure review. On the other hand, the discussion highlighted several areas where the SEC is considering possible actions. These include creating an explicit obligation for market-making firms to provide liquidity to the market, setting a limit on how quickly order messages can be submitted to exchanges, and imposing a cost on firms that cancel an excessive number of order messages.

Disagreement among Institutional Investors

During the roundtable discussion, institutional investors offered very different opinions on the effect of high-frequency trading on equity markets. Kevin Cronin, director of global equity trading at Invesco, complained that some high-frequency trading firms are trying to “take advantage” of institutional investors by using their speed advantage to jump in front of the investors’ orders. Not all high-frequency trading is bad, he agreed, but some of these firms are hurting the markets by “gaming the system.” This discourages institutional investors from posting orders in the displayed markets and encourages them to use dark pools, he said.

Taking the opposite view was Gus Sauter, chief investment officer at Vanguard. Sauter told the SEC that the emergence of high-frequency trading is one of many changes to market structure that combined to create important benefits for all investors. He emphasized in particular the decline in execution costs, which he estimated have fallen by 50% over 10 years. Although Vanguard does not use high-frequency trading strategies, Sauter said he sees it as a positive force because it “knits together” liquidity spread across many trading venues. “We think it is wrong to say that high-frequency trading firms are abusing the market,” said Sauter. “We think they are actually helping the system.”

A different criticism of high-frequency trading was raised by Sal Arnuk, co-founder and co-head of equity trading at Themis Trading, an agency broker that executes trades on behalf of institutional investors. Arnuk, who has been one of the most prominent critics of high-frequency trading, said that it is unfair that some investors have access to more information than others. He noted that some exchanges offer data feeds that allow market participants to pay a fee to receive market data faster than other participants. As a result the rest of the market is reacting to “stale data,” he said, and this gives the high-frequency trading such an advantage that trading becomes a “rigged game.”

Arnuk’s comment prompted a rebuke from David Cushing, director of global equity trading at Wellington Management. A firm cannot complain that it is “a victim of a rigged game” if it chooses to use stale data, he countered.

Principal Trading Firms Fight Back

The SEC also invited representatives of two principal trading firms to speak at the roundtable—Richard Gorelick, chief executive officer of RGM Advisers, and Stephen Schuler, chief executive officer of Getco.

Gorelick highlighted several main points from the joint comment letter submitted by his firm and three others—Allston Trading, Hudson River Trading and Quantlab Financial. In particular, he emphasized that studies based on empirical evidence show that by most measures the quality of U.S. equity markets has improved considerably in recent years. The changes to market structure that have allowed high-frequency trading to flourish have increased competition and provided lower trading costs, increased liquidity and improved price discovery, he told the SEC.

Schuler warned the SEC that the term high-frequency is misleading because it does not describe a single homogenous group of traders or a particular set of trading strategies. In his view, high-frequency trading should be viewed instead as a technique used to support different trading strategies. This explains why during the so-called “flash crash” on May 6 some firms withdrew from the equity markets and others such as Getco did not, he told the SEC.

Schuler emphasized that Getco’s principal trading activity is market-making. The firm provides quotes on both sides of the market and provides liquidity that benefits retail and institutional investors. He also questioned assertions that high-frequency trading has made the equity markets more volatile, pointing out that there have been many episodes in the past of extreme volatility.

SEC Chairman Mary Schapiro asked for their views on order anticipation and momentum ignition strategies, both of which were mentioned in the SEC’s concept release. Gorelick responded that momentum ignition strategies may be a form of market manipulation and if so the regulatory authorities should investigate. Order anticipation, on the other hand, “is what the market is supposed to do,” he said. That type of strategy is based on analyzing publicly available information on trading activity, and he urged the SEC to avoid taking any action that would restrict the ability of trading firms to use public information in their trading decisions.

Market-Making Obligations

A number of panelists raised the issue of whether liquidity providers like Getco should be subject to explicit market making obligations. Steven Sachs, director of trading at Diamond Hill Investments, an Ohio money manager with $7 billion in assets, said high frequency traders should have obligations to provide liquidity, and these obligations should be consistent across market venues. Christopher Nagy, head of order routing strategy at TD Ameritrade, an online brokerage that primarily serves retail customers, added that liquidity providers should have incentives to “step up and commit capital” for extended periods of time.

Other panelists predicted that even if market makers are required to provide liquidity on a continuous basis, they will back away from the market during periods of extreme stress. Ian Domowitz, a managing director at Investment Technology Group, an agency broker, commented that during the sudden plunge in equity prices on May 6 there was a drastic reduction in liquidity, but cautioned the SEC against trying to force firms to provide liquidity during such events. “No one steps in front of a freight train,” said Domowitz.

Vanguard’s Sauter cautioned that requiring market makers to provide liquidity during extreme volatility is essentially the same as requiring them to go bankrupt. He suggested that a better solution would to provide incentives for more orders to be displayed. Sauter urged the SEC to consider protecting quotes in the full depth of the order book rather than just at the top of the order book.

SEC Commissioners Raise Concerns

Schapiro raised the issue of cancellations, noting that some firms cancel more than 90% of the orders they submit to the market. What value does this type of trading provide to the market, she asked. Gorelick responded by agreeing that the market does bear a cost if quotes are too far away from prevailing prices or not adding value to the market. But he noted that this issue has been already been discussed and considered by the exchanges.

SEC Commissioner Elise Walter asked if there should be a requirement that quotes rest in the order book for a minimum amount of time in order to address complaints from some investors about “flickering quotes.” This prompted Getco’s Schuler to comment that speed, contrary to what many assume, actually reduces risk. Having extremely low latency access to exchanges allows Getco to constantly modify its quotes, he explained. This means less risk for the firm and tighter bid-ask spreads for investors. The SEC would be going down a “slippery slope” if it tries to force firms to post quotes for fixed amount of time, he warned.

Trading Pauses and Circuit-Breakers

One area where there appeared to be a consensus was around the use of trading halts to stabilize the markets during periods of extreme volatility.

Charles Jones, professor of finance and economics at the Columbia Business School, said that a “call auction” type of market model can provide better price discovery during periods of extreme stress than highly automated continuous markets. He noted that the CME succeeded in stabilizing its E-mini S&P 500 futures market during the May 6 turmoil by pausing trading for five seconds and expressed the view that this marked the turning point that brought the plunge in equity prices to an end.

Several panelists said they supported the recently issued plan to establish stock-specific circuit-breakers. This will halt trading in a particular stock for five minutes if its price dropped by 10% or more over five minutes. The new circuit-breakers, which are expected to take effect on June 7, will apply on a pilot basis to the 500 securities in the S&P 500 index.

Jeffrey Wecker, president and chief executive officer of Lime Brokerage, an agency broker that specializes in providing low-latency access to high-frequency trading firms, said stock-specific circuit breakers would allow “cooler heads to prevail” during periods of extreme volatility. Wecker praised the proposal as “a great start” in addressing the May 6 turmoil.

SEC Chairman Schapiro’s Opening Statement

SEC Commissioner Aguilar’s Opening Statement

Market Structure Roundtable Agenda and Panelists

Joint Comment Letter Filed by Allston, Hudson River, QuantLab and RGM in Response to SEC Concept Release

Comment Letter Filed by Getco in Response to SEC Concept Release

Webcast Archive (When Posted)