Interview with Walter Hendriks, ABR Financial

In the third of our High Frequency Trading interviews, we talk to Walter Hendriks, Managing Director of ABR Financial, a Netherlands-based investment firm providing liquidity to the major Pan-European financial markets. Mr Hendriks has been actively options trading since 1995, when he was a local trader on the Amsterdam Option Exchange. Before joining ABR in 2008, he spent three years as a Managing Consultant at CapGemini Global Financial Services, managing projects around Investment Banking, Asset Management, Clearing, Transaction Banking and Structured Products with several international operating Dutch banks, and advising European regulators on implementing MiFID and Market Abuse directives.

Mr Hendriks has had a number of papers published on topics such as European Asset Management, Financial Markets Regulation and Multilateral Trading Facilities (MTFs).

High Frequency Trading Review: Walter, what’s your definition of high frequency trading?

Walter Hendriks: Well, there are multiple angles to answer that question. The initial idea came from the exchange world, regulators, law makers, policy makers around the world, who wanted to improve trade matching to make it faster, to have more trades done electronically at the same time, matched, going to the various back end systems, clearing house etc., instead of via the old batch files sent twice a day depending on value dates, etc. So they came up with the idea of making this world electronic.

I’ve been on the trading floor trading derivatives since 1995, so I’ve seen how trading has evolved to keep up with the technology. In Europe, primarily due to MiFID and other European laws, there are now multiple exchanges and multiple trading platforms. We have the technology where we can roll out fiber through every part of the world and connect those trading platforms. This is obviously very different from what we used to do, when we were on the floor, physically bound to just one or two instruments, or underlyings for trading derivatives.

Everything went screen based because the exchanges wanted it, because the law makers wanted it, because clearing houses and everybody else wanted it, but at that time there was a lot of resistance from the traders themselves to give up their practice of writing tickets and trading in “the old style”.

So high frequency trading basically comes down to computer-based trading and having technology that’s powerful enough to do multiple trades per second. Unlike 15 years ago, when you could trade frequently but not highly frequently!

HFTR: So how does ABR get involved in high frequency trading?

WH: We try to make use of the power of IT in all its aspects to trade multiple markets and multiple exchanges. We look for small differences in the market based on our views, our algorithms, our calculations, and then we would do a certain trade. On top of that we have calculations or algorithms that decide whether we want to buy or sell options, buy or sell stock, buy or sell warrants or arb them versus other underlying instruments for example.

The IT world with all its aspects, with software, hardware, connectivity, switches, CPUs, memory, routers, etc., offers us a greater view of what is happening in the various financial markets. So we can trade more and more instruments at the same time, with less people.

HFTR: On the subject of multiple markets and multiple exchanges, how would you compare the high frequency trading landscape in the US versus Europe? What do you see as some of the main differences?

WH: Well, European markets are obviously lagging as always compared to the US markets. I’m involved in European multiple platform trading and we are less active on the US markets but as far as I can judge, they basically built & rolled out the MTFs (as we know them today here in Europe) 10 or 15 years ago. So their experience is probably a couple of years ahead of ours. I am not saying technology-wise they are ahead of us because Europe has been one of the primary parts of the world where technology has been a driver for innovation, for connectivity and for moving on in general.

HFTR: There are a lot of firms, particularly on the buy side, investment firms and so on, who say that a large proportion of high frequency trading is predatory. What would be your response to that?

WH: Well, let’s not forget the trading that was in the pits, on the trading floor 15 years ago. Regulators couldn’t even see what went on, they couldn’t even start managing the things that happened at that time and there were all sorts of prices on screens that were absolutely not realistic. So it has always happened.

But right now I am convinced that there are definitely people using algorithms or technology in a very unethical way, so regulators need to get a grip on that. They need to upgrade their IT efforts and spending, so that they can track that type of behavior. It is not very difficult; it just takes a few smart people to put their minds together to come up with a risk-based perception of what’s going on in the market.

As a regulator, you want to see what irregular behavior is taking place and this can be scanned easily, credit card companies are doing it right now. For example, we are sitting in a bar. If you pay for the drinks here with your credit card and then tomorrow morning you fly to Brazil and you buy some drinks over there with the same credit card, the bank will call you immediately asking, “Sorry sir, but are you in Brazil?” “Yes I am in Brazil.” Fine and that’s it. However, if you have paid for your flight ticket with your credit card, they won’t even call you because the system knows you’ve traveled to Brazil. This is behavior tracking and it’s already been done for years. This type of technology is almost common stuff nowadays and there is no reason why this type of risk-based analysis can’t be used by regulators as well. They just have to install the right software, use IT intelligently to get a grip on what’s going on in the markets, and not just look at their own national part of the world, because we now trade cross-border. They need to combine all data in a warehouse and scan it just like the credit card companies are doing.

HFTR: So whose responsibility would that be? CESR? (Committee of European Securities Regulation).

WH: I would assume that would be CESR, yes.

HFTR: You talked about risk and this is something that seems to come up again and again, the potential for systemic risk from high frequency trading. What do you see as some of the key risks involved in HFT? Are those risks understood? How can they be managed?

WH: Obviously this is a hot topic because of what just happened a couple of weeks ago in the US (the “Flash Crash” of 6th May). The last word hasn’t been said about it and we don’t actually know what the origin of that burst was. So people start pointing to computers, software, IT, things going haywire, which is fair enough. I understand it because that could – potentially - have been a reason.

But to be really honest, I would say initially any trading risk is the risk at the firm doing the trade. On the other hand though, if you want to take a wider view, these trading firms should have very good safety settings. No trade over a certain amount, no trade over a certain volume of instruments, no trading per one single order more than a pre-set limit, etc. Safety settings should be built into the system, so that if the computer loses connectivity with one exchange, then it shuts down its order strategy or whatever. Those types of safety settings should be implemented by every software vendor. Obviously there are companies that have built their own software, but they still need to have some sort of risk controls.

At the very least the clearing firm should be aware of what type of safety settings their client has implemented, so they can automatically move into “defensive mode” if any computer malfunctioning does happen, or to avoid doing the wrong or silly trades that could make the markets move the wrong way etc.

So you have to have good safety settings and rules in your systems. These same algorithms or calculations can be used by regulators, clearing firms and the proprietary trading firms themselves.

Then as far as volume or number of quotes or number of messages per second goes, the safety settings could be different from firm to firm. If you look at it from a high level point of view that is something that is very difficult to manage as a regulator. You can make a ruling or have post-trade checks by regulators saying “I’m going to inspect this firm and I am going to check whether they have safety limits in their systems”.

In the Netherlands for example, under AFM (Authority of Financial Markets) regulation, we have a “documented procedures manual” in case things go wrong. If IT goes down or you lose connectivity or you get in a certain position even that risk management does not want you to get into, how are you going to unwind this? Although these types of procedures, whether they’re handled by a computer or not, are proprietary to every firm, a regulator can still ask for documentation on how any firm is applying their safety settings, their safety rules.

HFTR: Do you think there’s a danger of the regulators having a “knee jerk” reaction to events like the Flash Crash of May the 6th? Is there a danger of regulations being put in place that are not conducive to a free and orderly market?

WH: Without a doubt. The regulators have some work to do to update their staff and themselves as an organization, to adapt to the very fast impact of IT that we’ve seen for the past 10 to 15 years. Trading firms have adapted and are using every bit and byte that they can find. At ABR, we are also updating computer CPUs, for example if Intel comes out with new updates, we look at how many cores we can use for which process and dedicate to certain types of trading. If we use that type of technology then regulators should really pick up on that as well.

However, we have had regulators come into our little trading office on invitation, when we actually invited them in to come and look over my shoulder and have a look at what we are doing. One of them looked at the order book and asked me, “is this real?” Just the fact that they asked the question basically says everything about what they know (or don’t know) about IT-based trading.

The next question they came up with is what we would think about the idea of having to send an order but keep it in the order book for a minimum amount of time. This is also the type of question that indicates to me that there’s a lot of work we need to do to explain how we operate. If we have to place an order in the order book for a minimum amount of time, then I’m not going to place that order because other people will be building algorithms calculating how long my order will be in there, looking for opportunities to hit my trade and hedge it somewhere else. So liquidity will then disappear from at least the MTFs, and the MTFs like Chi-X for example have done a marvelous job to make things more competitive for the professional world.

Also, what regulators have not seen happening is that MiFID was also aiming to provide best execution, not just to institutional investors but to retail investors too. But very few of the banks have changed their best execution policy to have their retail customers profit from MTFs and low-cost trading. So they are still sending all of their retail business to LSE and not to MTFs like Chi-X.

HFTR: So the retail order flow is not seeing the advantages of the MiFID best execution rules whereas the institutional order flow is?

WH: Absolutely. We can see that happening on Chi-X for example. US institutional trading firms connect to Chi-X and directly connect to the whole European 300-400 blue chips. They don’t need to connect anywhere else. They don’t need to connect to LSE, Euronext, Xetra, whatever, they connect to Chi-X. That gives them access to the whole European world of securities, which is only stock in this case but who knows? Optiver is currently building its MTF for derivatives and what’s next? Bonds, warrants, everything can be traded on an MTF at the end of the day. Obviously there would be some constraints as far as clearing and risk etc, but it’s very nice for the US institutional traders to connect with just one line to an MTF where you do not have to pay membership fees, do not have to work on a big infrastructure as far as connectivity goes, just connect to Chi-X and you’re done.

HFTR: OK, to wrap up, looking ahead 12 months or two years, how do you see the market evolving from here? Specifically in Europe but also globally. Where you see things going?

WH: It’s very difficult to be firm on this one. We can go the wrong way and CESR or the national regulators can come up with rules and regulations that can really affect the markets in a negative way. But I am very confident that there are some very smart people out there working for regulators, whatever level that is, whether national or European-wide and I am taking opportunities like these to give a little bit more clarity on what we do and what we intend to do.

We do not intend to be unethical about our trading; we are extremely transparent in what we do. I think the regulators just need to step up and put their money where their mouths are. They want to regulate the financial markets? Fine, but do it the way we trade, with IT. If they realize that and realize it’s not that difficult, then I think we can go the right way. So still there will be a MiFID II, maybe even a Market Abuse II updated to the IT world of trading and that’s fine with me because we’ve been growing very fast from writing tickets to completely electronic-based trading, from Helsinki to France to London, to New York, within fractions of seconds. Now we need the regulators to look at Europe as a whole not just on a national basis, because this way they will be able to monitor what’s going on.

So if we can explain to them what we do, and if they listen, I think in two, three years time these regulators will be more confident about how to approach the IT world of trading.

HFTR: Walter, thank you very much for speaking with us here at the High Frequency Trading Review today.