Algorithmic Trading Continues to Disrupt the Market

Friday, 20 Jun 2014 08:09 AM

By Barry Elias

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Despite lower trading volumes and volatility in recent years, algorithmic trading continues to disrupt the market. One successful trader recently told me: "The more opaque the markets are, the more money I make."

Since the financial crisis of 2007 and 2008, average daily bond trading has fallen nearly 27 percent, from roughly $1 trillion in 2008 to $734 billion today, the lowest level in more than a decade, according to the Securities Industry and Financial Markets Association.

The Chicago Board Options Exchange Volatility Index, a strong measure of investor expectation of stock market price movements, fell to 10.73, the nadir since 2007, according to FactSet, a financial data and analytics research firm.

Accommodative monetary policy by the Federal Reserve, in the form of low interest rates and huge increases in the monetary base, coupled with anemic economic growth and aggregate demand, have created strong upward pressures on financial assets, such as equities and bonds.

Expectations of low interest rates and greater capital requirements that increased trading costs have generated a more one-directional trading environment that inhibits contrarian investors. As a result, stock market volatility has fallen drastically, undermining trading models that derive income from large, rapid price movements and transaction volume.

Hedge funds typically utilize algorithmic trading strategies as part of their portfolio management operation. Despite a year-to-date rise of 5.4 percent in the S&P 500 Index (price appreciation plus dividends) and a 3.4 percent gain the Barclays U.S. Aggregate Bond Index, some major macro hedge fund players have experienced losses between 3 percent and 6 percent, including Fortress Investment Group, Braven Howard Asset Management, Moore Capital Management, Tudor Investment Corp., Caxton Associates and Hayman Capital Management.

Macro funds now manage $508 billion in assets, up from $279 billion in 2008, despite three years of disappointing returns, according to HFR Inc., a hedge fund tracker. Macro funds generally invest in stocks, bonds, commodities and currencies based on macroeconomic trends in global markets.

Steven Quirk, senior vice president of the trader group at TD Ameritrade, recently told a Senate panel that his firm routinely routes client limit orders to two trading venues — BATS Global markets and Citigroups's Lava Trading unit — to maximize payments for providing order flow, a maker-taker system.

This trading arrangement can have adverse effects on the investor public. Exchanges that have long wait times typically offer higher payments for order flow to attract more clients. As a result, the client's trade might get executed at a less desirable price or time — or it may never get executed. An order sent to an exchange with a lower waiting time — and associated with a lower payment — would have a higher probability of execution.

Thomas Farley, president of NYSE Group, which manages the New York Stock Exchange, suggested to a Senate subcommittee that he believes the maker-taker arrangements should be banned, since the fees, which are profitable to the NYSE, worsen conflicts of interest among brokers and create greater market complexity.

Securities and Exchange Commission Chairman Mary Jo White believes technology has ironically enhanced efficiency while causing severe and rapid market disruption.

Bradley Katsuyama, CEO of IEX Group, a trading venue that claims it is addressing these conflicts of interest, suggests the problem could be alleviated with greater disclosure and transparency in client order routing and other areas, since opacity is the order of the day for traders today.

As I mentioned earlier, opacity increases profitability for certain actors. It will take much disruptive innovation to right this financial ship.

© 2014 Moneynews. All rights reserved.

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