Digital technology has disrupted many an industry over the
last few years, but perhaps none more so than the business of
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 isnt 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 Columbias 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
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
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.
Meanwhile, the spread of high frequency trading in the
equity market is expanding beyond the United States. The
U.S. options and equity markets are well along, and high
frequency trading is also well developed in Europe. Now firms
in Asia are starting to reengineer their infrastructure to
reduce latency in the trading process, says Larry Tabb,
founder and CEO of financial market researcher the TABB
Are electronic venues and the high frequency
strategies that inevitably take advantage of them a
good thing for the markets? After the Flash Crash of May 6,
2010, high frequency trading was cited as a source of systemic
risk, and an SEC report pointed the blame at the fragmented and
fragile nature of the markets. High frequency trading firms
contributed to the problems that day by filling a $4.1 billion
mutual fund sell order for S&P 500 E-mini contracts.
However, Moallemi says that a longer view suggests that high
frequency trading may have made the equity market more
resilient. After the failure of Lehman Brothers in 2008, bond
markets froze up. But you could always trade
equities, Moallemi said. In the grand scheme of
things, central clearing and trading makes markets more
robust, he says.
Not everyone is so enthusiastic about the move to electronic
trading though, especially in the swaps market.
Equity or futures contracts trade in many thousands of
units a day, and are highly suitable for electronic execution
and clearing. But the bulk of CDSs trade less than 10 times a
day, J. Christopher Giancarlo, executive vice president
of GFI Group, told Institutional Investor in
December. Some trade only once a
day. In that event, requiring electronic execution is not
suitable. Less-liquid instruments require a lot of human
intermediation and negotiation. A market maker is not going to
let competing market makers see its position on a screen in
instruments with so few bids, so little liquidity. In that
case, there will be no liquidity, he warns.
Moallemi says some swaps may be unsuitable for electronic
trading, but that the he sees no reason why many products such
as 10-year interest rate swaps cannot be standardized, cleared
and executed via an electronic market. Interest rate swaps,
which he says are probably the largest component of the
derivatives market, are still largely conducted over the
The CDS market, which is associated with a relatively high
level of systemic risk, could probably make the
move to electronic trading, although Moallemi says it will not
be as easy to impose standards, and there are more
issues associated with electronic trading of CDSs
than there are with electronic trading of interest rate
Electronic trading is common in the foreign exchange market,
but not on a centralized basis. My understanding is there
are a handful of dominant players and not everyone gets treated
equally, Moallemi says.
He concedes that there will be some bespoke contracts that
always will be traded by phone between a handful of parties.
But by and large, Moallemi says the resistance to electronic
trading is economic and reflects the anxiety over publicly
displayed prices, high frequency traders and the disruption
that will follow.