06.14.2012
By Terry Flanagan

Fragmentation Harming Market Quality, Warn Traders

With new trading venues catering to institutional investors ready to enter the fray, market participants say that more fragmentation is not necessarily the solution to cure market imbalances.

‘Fragmentation of the markets is not a good thing for long-term investors,” Manoj Narang, chief executive and founder of Tradeworx, a hedge fund and technology firm, told Markets Media. “Regulators need to look at ways to defragment the market. The more different venues there are, the more traders who are technologically sophisticated are at an advantage.”

Narang asserts that market fragmentation hurts, rather than helps, longer term investors because the technology utilized by institutions is not as sophisticated and advanced as those used by high-frequency trading firms. They are less able to effectively wade through the plethora of lit and dark venues in the markets.

“Having more trading venues just complicates matters,” Dennis Dick, a proprietary trader with Bright Trading, a prop trading firm, told Markets Media. “We keep adding more and more layers, adding exchanges and adding dark pools, to try to find a solution, but really the solution is to break it down and start simplifying it all.”

There are currently 13 equities exchanges in the U.S., along with nine options exchanges. Many of the exchanges are operated under the same corporate umbrella, with NYSE Euronext and Nasdaq OMX each operating three equities markets and two options markets apiece. This is an addition to the 40-50 dark pools operated by independent firms and broker-dealers.

“Do we really need 13 exchanges and 50 dark pools and 200 internalizing broker-dealers,” said Dick. “I know the Securities and Exchange Commission had good intentions with Reg NMS but now we’ve gone too far the other way. We need to start simplifying. The solution is not to add more dark pools.”

Because of the controversy and negative light surrounding high-frequency trading on exchanges, which, some estimates say, accounts for more than half of all trading activity, many buy-siders have turned to dark pools specifically catered to institutional investors, especially for facilitating large block trades. These venues also proclaim to specifically block out HFT activity. New venues of this kind are continuing to come down the pipeline.

IEX Group, founded by former Royal Bank of Canada head of electronic trading Bradley Katsuyama, intends to protect mutual fund managers trading at its venue through the exclusion of HFT. The firm has hired employees from exchanges and HFT firms to help develop the platform. It is slated to launch next year.

While Barclays, UBS, BNP Paribas, Deutsche Bank and Royal Bank of Canada will all be backing a new foreign exchange trading platform, to be called traFXpure, that will cut down on flash orders from high-frequency trading practitioners. The venue will be run by Tradition, the Swiss inter-dealer broker.

In April, CA Cheuvreux, the equity brokerage arm of Crédit Agricole, launched a European equity trading platform, also aimed at institutional and retail traders. Called Blink MTF, the multilateral trading facility will trade 1,700 stocks across 14 European markets and will exclude the proprietary trading desks of big banks and high-frequency traders.

While these venues proclaim to block out high-frequency traders, it remains to be seen if they will be able to succeed with only institutional order flow. Especially as many dark pools, including those run by the big banks such as Credit Suisse’s Crossfinder and Goldman Sachs’ Sigma X, welcome high-speed algorithmic traders.

“Venues like that are never that successful, the notion you can have a market of just long-term investors and no short-term traders is a dubious concept, proven to be false many times over,” said Narang. “The reason why HFT firms now trade on many dark pools is because they were invited. And the reason they were invited is that otherwise the dark pool would have no volume. Long term investors are not natural counterparties with each other.”

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