The rise of high frequency trading over the last few years has unleashed a war between large financial institutions and a certain breed of hedge fund that preys on them by using computers to identify and front-run banks’ trades.
For the most part, the hedge funds have been winning this war. And they have extracted a heavy economic toll. While most institutional traders consider themselves to be expert at keeping a low profile in the markets, they are often outgunned by certain hedge funds that use high-speed network connections and trading algorithms to decipher and disrupt institutional orders.
Several years ago Rich Steiner, head of market structure strategy at RBC, estimated that the asset manager executed only 60 percent of its orders at the desired price. It had to pay a higher price to execute the remaining 40 percent of its orders.
The electronic-trading team at RBC decided to fight back against the problem of “phantom” or “disappearing liquidity,” which they blamed on a subset of high frequency traders using “predatory” tactics. That is how they came up with THOR, a system to help clients such as institutional money managers combat predatory HFT strategies and complete trades at the desired price.
The system has been in use for a year, and Steiner says it has greatly improved liquidity for RBC and its clients — allowing them to execute orders at the desired price.
Steiner says they had no quarrel with the majority of high frequency trading, which now accounts for 53 percent of the equities markets. That is up from 20 percent in 2005, albeit down from of peak of 60 percent in 2008. RBC itself uses some elements of high frequency trading.
“What concerned us are HFT strategies like latency arbitrage, which is just about getting from point A to point B faster, sniffing out large institutional orders like ours and trying to get ahead of them,” Steiner says
THOR is part of a broader institutional backlash against certain hedge fund strategies.
“Some institutional investors feel their orders are getting abused, and they are taking counter measures,” says Larry Tabb, founder of financial market researcher TABB Group. “On the buy side, RBC’s THOR is having the greatest impact.”
Large pension funds and asset managers buy and sell huge blocks of equity. Since their orders are so large, they must be broken into smaller pieces and executed over time in a series of different exchanges. If a large order is placed all at once, it can tip off other investors to the institution’s strategy and influence the price of the asset that is being traded.
Say an institution decides to buy a block of 100,000 shares in a company, spreading the order over half a dozen exchanges or alternative sources of liquidity to keep a low profile. As soon as the first part of the order is publicly displayed, the hedge fund buys shares of the target companies’ stock, driving up the price and forcing the institution’s fund to pay more for its order. The hedge fund profits from the rise in price, and the institution and its clients are on the losing side of the trade.
These transactions take place in fractions of a second. Hedge funds and alternative liquidity suppliers are allowed to locate their network connections at the NYSE Euronext data center in Mahwah, New Jersey. It is considered to be one of the most level trading fields in the world: All of the electrical chords that connect hedge funds and other financial institutions to the NYSE Euronext servers are the same length, so no investor can be physically closer to the servers than another. Such proximity would be enough to give one investor a speed advantage over others.
Since the physical playing field is leveled, the battle comes down to the sophistication of the institution’s order router and the hedge fund’s ability to develop an algorithm to “sniff it out.”
THOR works this way: RBC places an order for shares, breaking it into smaller pieces and distributing those pieces among a variety of exchanges. Traditionally those components of the order are executed all at once but arrive at their destinations in stages. Hedge funds detect the first part of the order, buying the stock in an instant and driving up the price before the other parts of the order can arrive. The entire battle is waged in microseconds.
THOR changes the execution of the order so that the discrepancies occur at the beginning, not the end. The parts of the order are dispatched in stages but arrive simultaneously at the various exchanges. As a result, hedge funds have a much tougher time interfering with the transaction. Steiner says that since THOR has been employed, 99 percent of its orders in Canada have been executed at the desired price. In the U.S. the fill rate is 98 percent, according to RBC. THOR is currently patent-pending for multiple geographies and asset classes and is in the process of launching THOR in Europe.
“We’re not trying to beat predatory hedge funds at their own game,” says Greg Mills, co-head of global equities at RBC. “We’re just trying to level the playing field for RBC and its customers.”