HFT's Treasury market penetration a clear concern

Dominance of opaque shops poses concentration risks

duncan-wood-2011-rev
Duncan Wood, editor

Following the furore over Libor and foreign exchange rigging, goodwill towards dealers is in short supply.

So perhaps it makes sense that dealers are picking a fight with the one group in finance that elicits an even more negative reaction from the public – high-frequency traders (HFTs).

But why? One of the main complaints is that HFTs use their superior technology to front-run dealers – cheating them out of pennies per trade, which over the course of thousands of trades adds up to a tidy profit.

The banks are hardly innocent bystanders, but following the prohibition on proprietary trading, they are almost exclusively buying and selling on behalf of end-users such as pension funds and corporates, which can explain the wider anger.

Some of it may also be existential. You could argue that high-frequency trading's increasing dominance in equity and fixed-income trading represents a point where lines of code buried in an algorithm have triumphed over human relationship-based trading. To borrow a quote from the poet Dylan Thomas, bank traders slamming the march of HFTs may just be raging against the dying of the light.

It could also be because nobody seems to knows much about these HFT shops. They make very few public statements, rarely speak to the press and, ironically, have little or no web presence. If they do speak in defence of their activities, it's to argue that they're providing liquidity at a time when dealers complain it's draining away. It's a fair point, but one dismissed by banks who claim the liquidity they provide is illusory.

The opaqueness of HFT firms should really worry anyone that relies on US Treasuries, either as a pricing input or as a trading instrument in their own right. The interdealer market is now dominated by these unregulated entities – as revealed by Risk – with highly regulated banks only providing a small fraction of liquidity on some platforms.

Will HFTs continue to make prices in Treasuries in times of severe volatility, or will they pull the shutters down to protect their own interests? Only they know for sure. However, a situation where arguably the world's most important bond market is heavily reliant on entities whose motivations are unknown is clearly a cause for concern.

Lukas Becker
(Duncan Wood is away)

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