The opposing viewpoints of these two veteran executives hint at the dilemma facing regulators as they try to determine whether to rein in high-frequency trading, which now accounts for at least half of all trading activity on U.S. exchanges.
Using sophisticated technology to execute transactions at blink-of-an-eye speeds, high-frequency traders have raked in billions of dollars worth of profits — a penny at a time — over the past few years. The ultimate question remains whether the value these firms bring outweigh the potential problems, from technological glitches that can trigger huge market disruptions to perceptual issues of fairness in the marketplace.
Brooks, who has spent more than 30 years at the T.Rowe Price trading desk, sees them as opportunists that are out to game the system without any regard for the fundamentals of the market. “Their game is about speed. It has nothing to do with investing,” he said. “They’ve found a loophole that needs to be closed.”
But Sauter says these traders are a lubricant for the stock market’s engine, providing liquidity and helping cut down transaction costs for all long-term investors.
“We do disagree on this one,” said Sauter, responding to Brooks’s comments. “I believe that there are some high-frequency traders who are trying to take advantage of us, but we are far better off with high-frequency trading than we are without it.”
An evolution of trading
Both men joined their respective firms at a time when the trading landscape was dominated by the New York Stock Exchange, which relied on specialists to match buyers and sellers on the exchange floor.
They witnessed the slow transition from manual to automated trading, which gained traction in the late 1990s when the Securities and Exchange Commission allowed electronic trading venues to compete with legacy exchanges.
As these venues proliferated, the SEC stepped in again in 2005, initiating a regulation designed to ensure that investors received the best available price for a stock. The rule allowed traders to bypass venues that did not immediately respond to their orders.
The changes prodded the NYSE to automate, and high-frequency traders flourished. Finally, they could use their high-speed tools to efficiently trade big-name stocks.
They do so by programming their computers to continuously scan the nation’s 13 exchanges and dozens of private trading venues, pouncing in a fraction of a second when they spot fleeting and tiny pricing inconsistencies.
While their techniques differ, the one known as “market making” has the most relevance to long-term investors. High-frequency traders engaged in that strategy stand ready to buy and sell at aggressive prices, injecting liquidity into the market, Sauter said.
They knit together the various trading venues, providing prices, speed and certainty, he said. As a result, he said, an institutional investor who wants to sell something doesn’t have to wait for another institutional investor to buy it, because high-frequency traders instantly fill the gap between supply and demand.
“We’d love an environment where if T. Rowe Price wanted to sell something and we wanted to buy it, we’d meet in the middle and go on our way,” said Sauter, a 25-year Vanguard veteran who is retiring at the end of this year. “Unfortunately, we can’t always find a T. Rowe Price at the opposite side of the trade. The high-frequency trader will buy from us and then turn around and sell it. They’re providing a social good to the marketplace.”
But T. Rowe Price’s Brooks says the liquidity offered by these traders is nothing more than a mirage, as demonstrated by the “flash crash” of May 6, 2010, when the Dow Jones industrial average plunged nearly 700 points in minutes and then recovered the loss.
High-speed trading exacerbated the crash, an SEC report concluded. The report also noted that high frequency traders withdrew from the market.
Brooks said that these traders have no obligation to stay active during times of stress, when the market needs liquidity the most, causing obvious problems for long-term investors.
“If we were not around, there would be no trading at all,” Brooks said. “If it were just them, the game would end.”
The pennies add up
For high-frequency traders, the profits come a penny at a time.
They trade large volumes of stock and they trade often. For instance, a high-frequency trader may bid to buy a share of Microsoft for $27.68 and immediately sell it for $27.69. A penny-a-share gain when you’re trading millions of shares a day adds up to a tidy profit — $1.25 billion in profits this year, according to Rosenblatt Securities.
The volume matters more than the price of the stock, Larry Tabb, the TABB group’s chief executive, told Congress recently. Making one cent a share on a stock trade of 10 million shares is a hundred times more lucrative than making $1 a share on a 1,000-share trade.
Sauter, whose firm does not engage in high-frequency trading, said he does not begrudge these traders the profit. By making their money in small increments, high-frequency traders have helped narrow spreads — the difference between what traders spend to buy a stock and the price at which they sell it to investors.
The increased liquidity and and tighter spreads have contributed to a 50 percent decline in transaction costs during the past decade at Vanguard, saving the firm’s clients millions of dollars, Sauter said. High-frequency trading may not be the only reason for the drop, but it’s a significant factor, he said.
Brooks sees it differently. These traders make money by betting against a T. Rowe Price or a Vanguard, he said. Institutional investors trade large blocks of securities, and they try to disguise what they’re doing by breaking those blocks into smaller pieces.
The high-frequency traders use their computers to “sniff out” the smaller trades and spot trends, enabling them to jump ahead of the institutional firms, Brooks said. If the firms are trying to buy certain shares, for instance, the high-frequency traders may then buy ahead of them and sell the shares back to the firms at higher prices — which hurts long-term investors.
Computer programs try to bait institutional investors by simultaneously placing millions of offers to see where they get a bite, then quickly canceling them, Brooks said. For every trade that gets bought or sold, 90 offers are canceled, the TABB group said. Most of the cancellations are initiated by high-frequency traders. Nobody knows for sure why the cancellation rate is so high, but Brooks has his suspicions.
“My sense is that a premise for high-frequency traders is as follows: They generate an action simply to watch our reaction,” Brooks said. “Then they position themselves to profit from that reaction.”
That’s always been the tension between market makers and investment firms.
Only now, Brooks said, it can be done cheaper and more efficiently.