Canadian Investment Review

ETFs and HFT: The Need for Speed

Written by Caroline Cakebread on Wednesday, April 9th, 2014 at 1:46 pm

speed trapHigh-frequency trading has been under regulators’ microscopes for a few years now, especially after the May 2010 Flash Crash that was widely blamed on activity amongst the algorithmic trading set. However, no one has managed to inject the level of drama into the practice like Michael Lewis in his latest book Flash Boys. Lewis is a great storyteller and his latest work looks like a ripping good yarn.

One topic that gets glancing treatment in the book, but has been linked to HFT in the past, is exchange-traded funds (ETFs). Given the controversy surrounding the book and the discussion it’s opened up, I thought it would be worth discussing.

The only reference to ETFs in Flash Boys occurs when Brad Katsuyama—the former trader at the centre of the story—is buying a Chinese ETF and finds that the price jumps suddenly just as he’s about to click the buy button. Kasuyama use this experience to show that markets are rigged.

This Financial Times article uses that incident to show a big missed opportunity in Lewis’s book to highlight a far bigger problem: that HFT is being employed by market makers (a.k.a. authorized participants) within the ETF space in the first place. Investors should know this and understand the potential risk, such as the ability of ETFs to significantly impact the prices of the underlying shares as traders feverishly buy and sell shares at lightning speed.

The thing is, all this isn’t news to regulators, which have been studying the potential effects of HFT for years.

More specifically, the Investment Industry Regulatory Organization of Canada (IIROC) made the link between ETFs and HFT in its 2012 study. IIROC found that high order to trade (or HOT) traders accounted for 32% of trading volume on exchanges and alternative trading systems in Canada between Aug. 1 and Oct. 31, 2011. Moreover, 21% of their trading is in ETFs and exchange-traded notes (ETNs) and they’re also responsible for more than half of the trading in these securities.

While that seems like a lot, is it necessarily a bad thing? What exactly does it mean for ETF investors? And could it impact the prices of underlying shares—and more importantly, market stability?

These are questions many regulators (IIROC included) are already asking. And they don’t yet have definite answers on whether HFT is really harmful to markets. Lewis’s book raises these questions again (and admittedly it’s way sexier than the HOT study—sorry IIROC).

The main message here is that we don’t yet have definitive answers. But it does raise an important question for ETF investors, specifically plan sponsors. Do you really understand the inner workings of ETFs and the role of the market maker or authorized participant working behind the scenes? What is the importance of market makers (and even HFT) in keeping the market rolling? This need for a clear understanding of what can be a complex process cannot be overstated in the ETF space.

Lewis’s book, drama and all, raises important questions—but investors should be asking them all along.

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