Interview with Ari Burstein, Investment Company Institute

In the latest in our series of High Frequency Trading interviews, we talk to Ari Burstein, Senior Counsel of the Securities Regulation – Capital Markets group of the Investment Company Institute (“ICI”).

Mr. Burstein is responsible for securities regulation issues affecting investment companies and investment advisers, particularly trading, market structure and brokerage related issues.

Mr. Burstein joined the ICI in October 1998. Previously, he was an attorney in the U.S. Securities and Exchange Commission’s Division of Investment Management from 1997-1998 and the Division of Market Regulation from 1992-1997.

Mr. Burstein is a member of the NYSE’s Institutional Traders Advisory Committee, Nasdaq’s Quality of Markets Committee, and the National Organization of Investment Professionals.

High Frequency Trading Review: Ari, what is your definition of high frequency trading?

Ari Burstein: It is difficult to put a specific definition on high frequency trading per se, certainly for regulatory purposes. There are a number of different trading strategies that can be described as high frequency trading and a number of ways that high frequency trading firms can be organized. With that said, while there is no formal definition of high frequency trading, the SEC in its Concept Release on the US equity market structure noted several characteristics that are often attributed to high frequency trading firms.

They listed five characteristics: the use of very high speed and sophisticated computer programs for generating, routing and executing orders; the use of co-location services; very short time frames for establishing and liquidating positions; the submission of numerous orders that are cancelled shortly after submission; and, maybe most importantly, ending the trading day in as close to a flat position as possible. I think that is a good place to start if you want to try to come up with characteristics that could define high frequency trading.

It is also important to distinguish between long-term investors, such as funds, and professional traders, such as high frequency traders. The SEC has described long-term investors as market participants who provide capital investment and are willing to accept the risk of ownership in listed companies for an extended period of time. You can certainly put mutual funds in that category. Unlike long-term investors, professional traders such as high frequency traders generally try to establish and liquidate their positions in a much shorter time frame. Because of this, some high frequency traders have different interests than investors such as funds, who are concerned about the long term prospects of a company.

HFTR: Now I understand the ICI is an organization that works in the interests of these long term funds and long term investors. So could you maybe run me through why high frequency trading is important to the ICI and what are some of the key issues as you see them?

AB: As you mentioned, the ICI represents the registered investment company industry, i.e. mutual funds, ETFs, closed-end funds and UITs in the United States. The structure of the securities markets definitely has a significant impact on ICI members. ICI members are investors of over 11 trillion dollars of assets, and at the end of 2009, held 28% of the value of publicly traded U.S. equity outstanding. It is also important to note that ICI members invest on behalf of over 90 million shareholders. Because of this, our members obviously have a strong interest in ensuring that the U.S. securities markets are transparent and efficient. Depending on what estimates you look at, high frequency trading in the U.S. equity markets account for at least 50% of the total market volume and most estimates bring this number up to 60% to 70% of the total market volume.

So, given the importance of efficient and effective markets to funds and their shareholders, I think any market participant that represents such a large portion of the total market volume is important to the ICI and its members.

It is also important to note (because there has been some confusion) that the ICI doesn’t object to high frequency trading per se. Arguably high frequency trading brings several benefits to the markets and to investors such as funds in those markets, including liquidity, tightening spreads and playing the role of the new market makers.

At the same time there are some potential concerns that we’ve noted around high frequency trading. These include the potential for gaming through the use of their high speed computer programs and the submission of numerous orders that are cancelled shortly after submission. Of particular concern to our members are some of the strategies that are employed by high frequency traders (as well as other market participants) that are often designed to detect the trading of large blocks of securities by funds and to trade either with or ahead of those blocks.

HFTR: So do you think there is enough transparency around what high frequency traders are doing?

AB: I don’t think there is enough transparency right now around high frequency traders and the practices of high frequency trading firms. I think that’s probably the issue that the ICI has highlighted the most to U.S. regulators. Greater transparency would certainly help regulators better understand high frequency traders and determine what, if any, regulatory solutions need to be implemented. It would also help investors make better informed decisions if we understood more about high frequency traders and high frequency trading firms. Transparency is needed in several areas - the manner in which high frequency trading firms trade, information about liquidity rebates and other incentives for order flow received by high frequency trading firms, as well as other potential conflicts of interest that may exist. These are among the key things that we would like to see.

HFTR: One of the things that you mentioned there was the high number of cancellations of orders that are sent by high frequency traders. There have been a number of discussions about a proposed cancellation tax (and I think Senator Kaufman has also raised this in one of his speeches) whereby if high frequency traders cancel more than a certain percentage of their submitted orders, there should be a fee associated with that, a transaction fee based on the number of cancellations. What are your thoughts on that?

AB: The ICI has talked about this in some of our comment letters to the U.S. Securities and Exchange Commission. If you are referring to some sort of a fee or a penalty to be imposed on cancelled orders, we think that’s an idea that is at least worthy of further examination by regulators.

If you look at what is occurring in the markets, there has been an increase recently in the use of certain types of orders to access liquidity. Arguably these types of orders have increased recently in part due to the growth in high frequency trading. So the use of these types of orders can really be a double-edged sword. While the high frequency traders are employing these types of orders to provide liquidity to the market, our members’ concern is that a lot of the order flow from these types of orders only provide a kind of “noise” to the market and that they only offer fleeting liquidity in small size—it’s only there for a short period of time. It also can provide a confusing indication of the national best bid and offer (NBBO) in the United States. We also are concerned that some of these orders are predicated upon some informational advantages about trades or orders or are attempts to ferret out the existence of larger orders being executed by funds, in order to trade ahead of or with these types of orders.

HFTR: You may have seen the paper that came out of Themis recently arguing that where firms co-locate their black boxes at the exchanges, they potentially have an unfair advantage through being able to see prices before the rest of the market. Do you see exchanges that offer co-location as being complicit in offering some firms an unfair advantage? Is it a level playing field or not?

AB: According to the SEC, the terms of co-location services can’t be unfairly discriminatory, and the fees surrounding those services has to be reasonable and equitably allocated. Those are the appropriate standards by which regulators should judge co-location services and I think rather than banning such services, regulators should subject them to standards that ensure fairness and equity. So we don’t necessarily have a position on whether co-location provides an unfair advantage. As long as co-location services are offered in a fair and equitable way regarding practices and fees, I think that should be sufficient.

HFTR: Moving on to the question of dark pools. Over the last few years, there has been a proliferation of multilateral trading facilities (MTFs) where orders are not displayed, both in the US and in Europe. Do you see dark pools as beneficial to institutional investors or not?

AB: There has been a lot of discussion in the United States and, as you mentioned, in Europe about so-called dark pools and there has also been a broader discussion about undisplayed liquidity in general. I think you need to take a look at both.

Funds have been long-time significant users of all types of undisplayed liquidity and all the trading venues that provide undisplayed liquidity. These venues, including dark pools, provide a mechanism for transactions to interact without displaying the full scale of funds’ trading interest, which is critical to ICI members. Undisplayed liquidity allows funds to avoid transacting with other market participants who seek to profit from the impact of the public display of large orders, to the detriment of funds and their shareholders.

As we stated in numerous letters to U.S. regulators, one of the key things that we look at when examining new regulations and proposals is the impact on the confidentiality of information about fund trades, which is very significant to our members because any premature or improper disclosure of this information can lead to front running of a fund’s trades, which adversely impacts the price of the stock that a fund will get when it is buying or selling.

Funds ideally would like to see as much liquidity as possible executed in displayed markets. With that said, I think there is a real value in enabling funds that frequently trade in large size to have access to venues that don’t disclose their trading interest.

We would be concerned if regulators were to impede mutual funds’ ability to trade securities in venues providing undisplayed liquidity, including dark pools. I am sure, given the current market structure, that funds will continue to be significant users of dark pools and other undisplayed liquidity venues.

HFTR: Now earlier in our conversation you mentioned potential conflicts of interest around liquidity rebates. Can you talk us through what you see as being those potential conflict of interest?

AB: Any incentive that exists now for market participants to route orders to particular venues and any other related conflicts of interest needs to be examined by the regulators. As far as liquidity rebates, we would be concerned if a broker, for example, refrains from posting a limit order on a particular exchange because it offers a lower liquidity rebate than other markets, even though that exchange may offer the best possibility of an execution for a limit order. So practices such as these, if they occur, may ultimately harm investors because their limit orders may not be executed. I think at the same time it is unclear what benefits investors gain from liquidity rebates as opposed to trading firms such as high frequency trading firms.

With that said, the ICI doesn’t recommend that liquidity rebates be prohibited at this time but we do recommend the SEC and other U.S. regulators at the very least require more transparency around these practices and the revenue that market participants are receiving or generating by these rebates.

Once the SEC gets this data, we would recommend that it examine the data and determine whether rule making is necessary to address any concerns that are identified.

HFTR: Now throughout our conversation you’ve highlighted a number of things that the SEC and the regulators should be looking at. Do you think that the regulators generally have a handle on these issues and are they taking the right approach or is there anything that they should be doing differently?

AB: I think the regulators are definitely taking the right steps. There’s an immediate need for more information about high frequency traders and the practices of high frequency trading firms. It may be difficult for regulators to answer definitively all of the questions surrounding high frequency trading until there is more information about their practices and operations.

With that said the SEC has taken several steps to try to increase information about high frequency traders and high frequency trading firms - they issued the Concept Release and have received a lot of good responses back, albeit with differing views.

They also have proposed a large trader reporting system that would allow them to better identify large market participants such as high frequency traders and collect information on their trades and analyze their trading activities. They also recently proposed a more comprehensive consolidated audit trail that would enhance information about trading in the markets and they’ve held a couple of hearings where they have stated that they will address the other market structure issues that are associated with high frequency trading. So I think that they are definitely going along the right path and I think we will certainly see more going forward.

HFTR: Okay, so any predictions for the year ahead? How would you see the structure of the market changing over the next twelve months?

AB: I think you will see the SEC continuing to focus on examining the current structure of the US equity markets and whether the rules governing the markets have kept pace with the changes in technology and trading practices such as high frequency trading.

I think some of the issues that were considered by the Concept Release and some of the other market structure proposals have taken on increased importance following the events that occurred in the US markets on May 6th, the so called “flash crash”, which has raised different market structure issues that the SEC now has taken on. So there is definitely a lot on the SEC’s plate.

It is clear that some of the large and sudden price dislocations that we saw on May 6th were at least in part the result of inefficiencies in the market structure. So I think in the year ahead there is going to be a lot of scrutiny and examination of the current market structure, market participants and some of the ways that firms trade.

HFTR: Thank you Ari.