Digital technology has disrupted many an industry over the last few years, but perhaps none more so than the business of trading stocks.
High frequency traders tripled their share of the U.S. equity market from 20 percent in 2005 to 60 percent in 2008, although that share has since fallen to about 53 percent, according to RBC Capital Markets. Using high-speed, fiber-optic networks and sophisticated computer algorithms, traders can execute orders at speeds that were unthinkable just a few years ago. “We have found that anything north of 500 microseconds just isn’t fast enough,” says Rich Steiner, head of market structure strategy at RBC. That technology has driven many changes in the equity business including altered margins, new liquidity and trading patterns, and the rise of alternative exchanges, to name just a few.
Market experts say the dramatic changes that have occurred in the equities world are about to repeat in other markets such as bonds, derivatives, commodities and currencies, where much business is still transacted over the telephone or via nonpublic electronic venues and where prices are not fully displayed. “High frequency trading is going to transform many once bespoke markets, just the way it changed equities,” says Ciamac Moallemi, associate professor of decision, risk and operations at Columbia’s Graduate School of Business.
Multiple forces are pushing high frequency trading deeper into new territory, and for reasons that are very different than those in the equity market, according to Patrick Whalen, head of buyside trading at AllianceBernstein. Whalen, a former Lehman trader, got his start in equities and now focuses on an array of asset classes. The growth of high-speed trading in the equity markets in the U.S. was driven by the Securities and Exchange Commission, which wanted to make sure that individual investors received the best execution for their orders. In the swaps market, the move to electronic trading is the result of regulations adopted after the financial crisis. The point is to control systemic risk.
While regulators in many countries are mandating public clearing of swaps, in the U.S. the Commodity Futures Trading Commission wants to go one step further and demand electronic execution of swaps as well. The swaps market is still conducted mostly over the phone. Dealers conduct calls with a limited number of potential buyers — a handful, if that. And it remains an extremely lucrative business. Electronic trading could reduce transaction costs in the swaps market to $35 billion a year from $50 billion now, according to some estimates.
In the fixed-income markets, government policy is encouraging electronic trading. The transformation may not happen as quickly as it did in the equity market, but it is under way. The Volcker Rule, which will force commercial banks out of the business of proprietary trading, will prevent banks from keeping assets on their books, reducing returns and compelling them to sell fixed-income assets quickly and efficiently. Under those circumstances, electronic trading becomes a necessity. “Banks can no longer warehouse risk. They need to move it as quickly as possible,” Whalen says. “The price of liquidity is changing. Things that are illiquid are becoming more expensive to hold,” Whalen says, noting that so-called on-the-run (or most recently issued) Treasuries are cheaper than off-the-run Treasuries.
As interest rates rise, there may be less corporate debt on the market, pushing a drive for cheaper and more efficient trading via electronic venues. “Corporations may not issue new debt every two or three months,” Whalen says. As a result, there may be fewer instruments, written to common standards and traded in more liquid, electronic markets.
The shift to electronic trading will usher in changes in liquidity patterns. For example, electronic trading “is not great for moving large pieces of inventory,” Whalen says. In a market where prices are publicly displayed, institutions cannot offer a large block for sale all at once without pushing down the prices of the asset they are trying to sell. “You have to bleed it out into the market a little at a time without leaving a footprint,” he says. That is particularly true in markets such as equity and fixed-income, where the price of securities is driven by the fundamentals of the company that issued them. It is less true in markets such as currencies and commodities. While the price of 100 different stocks will vary wildly, a Swiss franc is a Swiss franc regardless of who owns it.