GETCO's Arrival on the NYSE Floor Raises Tensions on the Buy Side
Wednesday, April 28, 2010
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By Ivy Schmerken
When NYSE Euronext announced in February that GETCO, one of the biggest players in high-frequency trading, would become a designated market maker, or DMM, on the New York Stock Exchange floor, the news immediately became a hot topic among both the buy- and sell-side communities. As a DMM (the revised term for an NYSE specialist), GETCO posts bids and offers in 350 NYSE stocks. The firm, which officially assumed the role in April, rolled out about half of the symbols within the first two weeks.
As a major proprietary trading firm, GETCO has commanded a certain mystique. Now, however, the closely guarded firm known for its electronic market making has decided to play an important, very public role at a brand-name exchange. But given the controversy swirling around high-frequency trading and the intense SEC scrutiny the trading style has received in the past year, the news about GETCO's new DMM status has raised concerns among buy-side traders.
"We've always viewed ourselves as a market maker, and this DMM opportunity is another extension of our core business," explains Dave Babulak, managing director of GETCO. "That's the core of our business. The vast majority of our orders are passive liquidity."
Change Is Coming
Why did GETCO, a global electronic market maker in all asset classes -- including equities, fixed income, futures and commodities in the Americas, Europe and Asia -- decide to become a DMM with a floor presence? "These opportunities are rare," says Babulak, who explains that the firm bought a chunk of the former specialist LaBranche's business from Barclays. "This is an opportunity to make markets in a different market structure."
With 22 percent market share, the NYSE constitutes the biggest pool of liquidity in NYSE-listed stocks and one with which a computer-driven trading firm such as GETCO wants to interact. GETCO already was an electronic market maker in U.S. equities on BATS, Nasdaq and NYSE Arca, as well as a supplemental liquidity provider, or SLP, in 500 NYSE stocks. Some market participants argue stepping up to the DMM role was the logical next step.
"It's a high-profile role," says Joseph Mecane, EVP and chief administrative officer for U.S. markets at NYSE. From the exchange's perspective, "GETCO is our largest SLP -- they had experience with our marketplace, and the DMM evolution is just really the next step in growing with the NYSE model," he explains.
"GETCO is obviously a large participant in the marketplace," Mecane adds. "As they look at additional ways to get involved in the marketplace, our model is an attractive model for them."
The liquidity GETCO supplies to the market is a positive for issuers and the NYSE, Mecane continues. "They have insight into stocks," he insists. "We think they'll be able to make tight markets on their platform, which is good for investors."
About a year ago, the NYSE revised its market model to add value to the specialist role and introduced the new DMM designation. Meanwhile, a year earlier, the exchange had created the SLP role. At the same time, the NYSE revamped its technology and rule set to be more friendly to high-frequency trading firms. Sources credit the new market model, including the start of the SLP program and the introduction of the DMMs, with helping the NYSE stabilize its market share in the wake of the fragmentation of listed volume across multiple trading venues that stemmed from the introduction of Reg NMS. GETCO currently is one of only five firms -- along with Goldman Sachs, Kellogg Group., Bank of America and Barclays Capital -- serving as NYSE DMMs on the floor.
A Cautious Buy-Side Response
But buy-side firms still are not comfortable with high-frequency trading firms interacting with their customer order flow. "It's a mixed blessing," comments Jennifer Setzenfand, VP and senior trader at Federated Investors in Pittsburgh. "I don't like it, but I do like the fact that they are opening them up to regulatory scrutiny," she adds, suggesting that the DMM role will subject GETCO to more oversight by the NYSE and the SEC.
"You've got to keep in mind that not all high-frequency [trading] is bad," Setzenfand acknowledges. When HFT shops supply "the volume you need at the time you need it and the price that's desired, that can be acceptable. But if your information is taken away from you and used against you," that is the problem, says the buy-side trader.
As soon as the news that GETCO would take on the DMM role at the NYSE broke, buy-side firms voiced concerns to their sell-side brokers. "We had some very large clients express skepticism about if this was good for U.S. markets," relates Timothy Reilly, managing director and head of electronic execution sales for the Americas at Citi.
"For the past year, the majority of the institutional trading community has consistently asked us to avoid GETCO," notes a sell-side trading executive who requested anonymity. "However, going forward, when certain stocks are routed to the NYSE, they will be potentially trading against GETCO's designated market making unit. That said, we work in a highly regulated marketplace, and participants are mandated to route according to [Reg] NMS and best execution requirements regardless of their initial skepticism."
Some concerned buy-side firms have even instructed their sell-side algorithm providers to avoid GETCO's dark liquidity pool, known as GETCO Execution Services, according to the sell-side trading executive. GETCO Babulak explains that although GETCO only markets the dark pool to sell-side firms, buy-side firms can receive executions from GETCO's ATS through their sell-side algo providers.
But institutions no longer can avoid interacting with GETCO now that it is a DMM. Under the NYSE's revised rules, as long as the DMM is quoting at the inside price (NBBO), it trades on parity with the other exchange members, meaning it can jump to the front of the line for a piece of the order.
"Parity means it's not pure price-time priority. If the DMM is at the NBBO and an order comes in, the DMM may get a piece of that order," explains Babulak. "It's an incentive to post quotes at the NBBO."
Bilateral Support?
Given that GETCO already was a major liquidity provider on the NYSE, sell-side firms view the change as a natural evolution of the firm's role. "This is just another step in the full integration of electronic trading and high-frequency market making into the exchange world," observes Joe Gawronski, president and COO of Rosenblatt Securities, an institutional agency broker that specializes in market structure analysis.
"Obviously they're already involved," says Gawronski, who notes that high-frequency trading already accounts for one-half to two-thirds of U.S. equity trading volume. "But to make one of the leading [high-frequency trading] firms a DMM -- it's sort of like taking HFT out of the shadows and bringing it into the light under the mantle of the NYSE," he adds, noting that the move may make HFT more legitimate in certain critics' eyes.
Nonetheless, buy-side firms want to know how separate the DMM role is from the proprietary trading business of the overall firm, which is permitted to pursue other trading strategies. "Clients want to understand the precise relationship between GETCO's primary market making businesses and their NYSE DMM unit," says the sell-side electronic trading source.
Others question whether HFT shops provide liquidity to small and mid-cap stocks or only to the top 100 large caps.
That view is "misinformed," GETCO's Babulak insists, pointing out that the firm is active in 2,500 stocks every day. "We have a pretty deep market penetration." According to Babulak, GETCO trades 50,000 shares a day in many of its less-liquid stocks, where it has an affirmative obligation to make continuous markets.
In fact, some buy-side traders are less skeptical. Gus Sauter, chief investment officer at Vanguard, which manages about $1.4 trillion in mutual fund assets, says he doesn't think high-frequency traders deserve the black eye they've been given. "I don't see this as a negative development. This is sort of a natural evolution," he comments. "GETCO has been serving as a supplemental liquidity provider on the exchange, so to move to a DMM is an incremental step and one that we hope will be sufficiently monitored."
Sauter emphasizes that Vanguard performs it's own monitoring as well, regardless of the firm with which it is trading. "You always have to monitor the trading that you do, and make sure you're getting best execution and make sure you're not being gamed," he says.
In Sauter's view, it really comes down to trusting the NYSE to police the new breed of electronic market makers. "It's got nothing to do with GETCO. If the NYSE had any problems with this model, the exchange would have a lot to lose," he says.
"We are already highly regulated," GETCO's Babulak responds. "As a registered broker-dealer, we're regulated by the SEC and CFTC. Regulated markets are important. We're out there -- posting orders for other people to trade with. As a market maker, we need well-regulated markets."
Obligations and Privileges Amid HFT Concerns
Rosenblatt's Gawronski notes that because GETCO has obligations as a DMM that it didn't have in its SLP role, there could be benefits to the broader market of having the firm serve as a DMM. "There are obligations and privileges that come with the DMM role," Gawronski says. "They certainly have more obligations than an SLP. You have to deal with the corporate issuer's management, there are certain responsibilities at the open and the close, and requirements of how often you have to quote at the NBBO."
Of course, serving as a DMM can significantly add to GETCO's profitability as well. The DMMs receive a higher rebate for supplying liquidity than any other class of exchange member -- 30 cents per 100 shares versus 17 cents for SLPs.
"I've been pounding the table that high-frequency traders need to legitimize themselves," Federated Investors' Setzenfand says, noting that one of the criticisms against high-frequency traders is that they don't have obligations as a market maker. "If you want them to be counted, registered, identified, this is kind of a step in the right direction. Yes, they get benefits, [but] they actually have obligations they didn't have before."
Still, there is a certain shroud over electronic market makers and how their obligations will work with high-frequency trading to drive profits that seems to instill fear in the buy side. "As a market maker, we post two-sided markets," explains GETCO's Babulak. "Other people buy and we sell it to them, and if we do our job correctly, we manage to hang onto a little piece of the bid/asked spread."
Despite a lack of tangible evidence that high-frequency trading damages the equity markets, allegations that certain strategies front-run orders or manipulate prices persist. "Today we operate in a marketplace where many people hold conspiracy theories," says Citi's Reilly.
But, "Customers have appropriate concerns about predatory order flow and information leakage," he acknowledges. "So it's not shocking that GETCO's arrival on the NYSE floor is making some traders a little uncomfortable."
GETCO's Babulak suggests there are many misunderstandings surrounding high-frequency trading. "High-frequency trading is not an industry, it's not a strategy -- it's a technique," he asserts. "Our view is that we use HFT as a technique to help us to make markets. It's just the natural evolution of how people have always made markets. It's applying technology to it."
Not everyone is completely convinced. "There's whole lot that we don't understand about how the electronic market works," says Federated Investors' Setzenfand. "On the front end they have to meet regulatory scrutiny. But I just don't think that anyone understands what happens to our information post-trade."
Something Old, Something New
Despite the concern and controversy, the buy side can't avoid interacting with high-frequency-trading flow. Reg NMS actually compels the buy side to interact with the NYSE quote, Citi's Reilly points out. "Historically there's never been a regulatory obligation to interact directly with these type of prop-driven platforms," he relates.
The NYSE's Mecane admits that the exchange had to address questions from the buy-side when the GETCO news broke. "There's been a lot questions, a lot of curiosity," he says. "People want to see what effect it has on the marketplace. The general way we've communicated it is we expect this will draw more liquidity to the platform. I think if that's the case, institutions will be pleased with it."
But even if it were not for Reg NMS and GETCO's new status as an NYSE DMM, electronic market making simply has become too pervasive for the buy side to avoid HFT order flow, GETCO's Babulak and other sell-side sources point out. "We make markets on Nasdaq, BATS and Arca. We've been an SLP on NYSE," Babulak says. "When you look at a public quote, there's a pretty good chance you're seeing GETCO prices there."
HFT firms already account for one-half to two-thirds of the average daily U.S. equity trading volume, based on estimates by Rosenblatt Securities and TABB Group. "I find it a little bit amusing that there are buy-side firms that don't want to trade with [an electronic market making firm] because just about every buy-side firm [already] is trading with high-frequency firms at some point," says Jeffrey Wecker, CEO of Lime Brokerage, an agency broker that provides connectivity and low-latency infrastructure to high-frequency shops.
According to Vanguard's Sauter, a number of DMMs already pursue trading activity that could be considered high-frequency trading. Pointing to the electronic market making activities of Barclays and Goldman, Rosenblatt's Gawronski notes that several of the NYSE's DMMs have been trying to make the transition from the old specialist world to the new model.
Further, some experts suggest that including high-frequency trading shops such as GETCO -- with their sophisticated computer programs and expertise in trading derivatives -- will bring a new skill set to risk management. "I do believe they control risks -- that's what high-frequency-trading firms do," comments Vanguard's Sauter. "They're really playing into discrepancies in the market and closing those discrepancies. They do that because of the technology, and the by-product is that they're bringing tremendous liquidity to the marketplace."
Ultimately, most buy-side traders acknowledge that electronic market makers are the way of the future. "If they're making a market for me, and it's a tight bid-offer spread, the fact that they're using computer technology doesn't scare me," says Sauter. "People want to paint [high-frequency traders] as bad guys. They're the current day market makers. The world is electronic -- why shouldn't the market makers be electronic? If you don't evolve, you become a dinosaur."