High Frequency Trading: a Look at How Much the Exchanges Make

By Nicholas Maithya

High Frequency Trading has been a hotly featured subject in recent times, as media and regulators continue to talk about the structure of U.S. markets, with a keen focus on equities trading. The media and regulators have been able to pinpoint the downside of high frequency trading.

This revelation has brought High Frequency Traders, and the market structure elements that run High Frequency Trading under siege. Consequently, this is likely to impact adversely on High Frequency Trading, thereby reducing the revenue streams of various exchanges, including CBOE Holdings, Inc. (NASDAQ:CBOE), NYSE Euronex (NYSE:NYX), and The NASDAQ OMX Group, Inc. (NASDAQ:NDAQ), among others.

In 2011, CME Group Inc. (NASDAQ:CME) collected more than $1 billion in High Frequency Trading Revenues, whereas NYSE Euronex (NYSE:NYX) reported $573 million. A majority of the Exchanges are expected to register a decline in High Frequency Trading revenues in 2012, apart from The NASDAQ OMX Group, Inc. (NASDAQ:NDAQ), and IntercontinentalExchange, Inc. (NYSE:ICE).

The proponents are suggesting imposing sanctions on High Frequency Trading, to limit the activity, in a bid to avoid future market flaws, as recently noted in a sequence of events. There is a clear chronology of events that have played a big part toward this call.

On May 6th, 2010, there was a flash crash resulting from wild swings in the Equity Markets,

Earlier this year, on March 23rd, BATS withdrew its IPO, following major technical errors, which the company branded as a software bug, which prevented it from trading.

On May 18, a date that a majority of investors remember; Facebook Inc. (NASDAQ:FB) set foot on the NASDAQ stock exchange, and on the opening day, even before trading started, traders had to wait for about 30 minutes, due to some technical glitch. Consequently, this resulted in hundreds of millions of dollars in, trading-losses.

Last Month, August 1st, Knight Capital lost about $440 million in less than two hours, as a trading glitch once again took all the blame.

Finally, this month, September 14, the NYSE was fined $5 million for inadvertently disseminating market data information to proprietary data feeds, before sending the information to the consolidated tape.

The fragile nature of the market structures, compounded by the view that market changes have had an adverse effect on institutional investors, is a clear picture of the predicaments that lie beneath High Frequency Trading, where market structures fail to keep up with the speed. Perhaps, its time we gave them some speed governors, to regulate that velocity.

Technological advancements are beginning to take a toll on structures, and it will be tough to come up with a clear framework that can finally harness the situation. Even Germany is noted to be considering tightening the rules that govern High Frequency Trading, as so often, the market has fallen victim to the high speed buying and selling of securities.

Nonetheless, as the Securities Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC), ponder the various measures to take, it is also good to look at the overall impact to the market. Indeed, imposing various limitations, either on the frequency of transactions, or volumes, will also affect other areas, such as various exchange revenue streams, market data, and co-location revenues.

CME Group Inc. (NASDAQ:CME) stands to have nearly 32% of its revenues affected by any regulations implemented to limit the activity of High Frequency Trading, while The NASDAQ OMX Group, Inc. (NASDAQ:NDAQ) will have 17% of its revenues affected.

Wholesalers and other brokerages could also be on the losing side; this is because the SEC is expected to implement rules that will limit off-exchange trading, which accounts for nearly one-third of U.S. market equities trading. The U.S. markets are very fragmented, and this is merely because of High Frequency Trading that allows a good number of transactions to take place off-exchange, through various online trading systems.

Analysts are of the opinion that High Speed Trading does give some traders an unfair advantage over their exchange traders, by enabling them to pass a transaction within a split second. A report published in Blog Maverick, claims that High Frequency Traders are generally hackers, by comparing them with “a person who gets in front of your shopping cart to grab your credit card then sell it to you”, in the case of HFTs, “the high frequency trader jumps ahead of your trade, to purchase a particular stock, then sell it to you at a premium”.

Jim Chanos of Kynikos Associates claims that he is not active in High Frequency Trading and admits that he is very aware of the level of unfairness this method of trading brings to the market, referring to it as “split second trading”.

Nonetheless, there are catches to implementing regulations on High Frequency Trading any time soon. According to Raymond James research analysts, there is no time frame yet for any implementation of a policy that would seek to regulate the affairs in High Frequency Trading. Additionally, the SEC is currently tasked with the implementation of the Dodd Frank Act. The proceeding are about midway, and hence beginning another implementation process could result in overhang. This is why, it is likely to take too long to implement rules on HFT.

The analysts also believe that there is the slightest of chances that the CFTC would get involved in this, as there are good structures in the futures markets, which have held firmly, and there is no such fragmentation as witnessed in the equities markets. The analysts expect the CFTC to focus on improving investor safeguards, rather than making fundamental changes to market structure. Nonetheless, it is understood that the CFTC would be drafting a concept release to look further into the issues; therefore, the exchanges could be affected too.

MFP Investors’ Michael Price has put much of the blame on the SEC, claiming that the commission has failed to put measure to the two major exchanges The NASDAQ OMX Group, Inc. (NASDAQ:NDAQ), and NYSE Euronex, claiming, “they sold their soul to the devil”, as they draw high profits from High Frequency Trading.

High Frequency Trading allows brokerages to execute transactions quickly, without having to physically, transfer any money to various user accounts. This allows investors to take multiple positions on a certain instrument within a day, which Chanos believes is a bit unfair to on-exchange traders. Chanos believes that High Frequency Trading is here to stay, but the expected regulation changes could be spelling doom to high speed trading.

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