Flash Boys, the latest book by financial journalist
and Vanity Fair contributing editor Michael Lewis,
describes a world of high-tech electronic trading in which
running cables between exchanges can make a milliseconds
difference between profit and loss and in which arbitraging the
slow-moving dinosaurs to make riskless profits is the name of
the game. Lewiss March 30 appearance on the
Sunday evening news program 60 Minutes, with the
indictment that markets, as Lewis put it, are
rigged, has sparked spirited debate across the U.S.
high frequency trading (HFT) the practice of buying
and selling securities at extremely fast speeds.
Equities trading has become so replete with information that
knowing how to code and how to game the algorithm is as
important as understanding the ebbs and flows of the markets
themselves. The modern demands of trading require a speed of
execution that humans cant replicate.
Clients want efficiency, says Brian Pomraning,
head of electronic client solutionsEurope/Middle
East/Africa and liquid markets products at J.P. Morgan in New
York. They have the need to execute hundreds of orders.
Our algos can process orders and react to any variables at any
time across a wide range of securities and sectors. They allow
functions that a single human brain cannot perform.
The broker focus on HFT isnt surprising. Equity
trading volumes have been lurching downward since the financial
crisis and hit 15-year lows last year. There were 30 percent
fewer trades in August 2013 than in August 2007. In 2012
equities were at 55 percent of 2007 levels, according to
research from New Yorkbased global management firm Oliver
Wyman. HFT firms offer liquidity, and electronic trading
Wall Street has culled many of the high-profile desk traders
during the past few years as a cost-cutting measure after the
200809 financial crisis. In addition to fewer human
traders, the advent of HFT pushed the envelope on execution. In
the battle to compete with HFT firms, banks embarked on an arms
race to improve their technology, reduce latency (the time it
takes for a trade to be executed from the moment it is placed)
and develop superior quantitative algorithms to search for
liquidity in the darkest recesses of the market.
A shrinking buy-side commission pool, driven by regulatory
changes such as the U.S. Securities and Exchange
Commissions Regulation National Market System (Reg NMS)
and the European Unions Markets in Financial Instruments
Directive (MiFID), both of which push for fairness in
fulfilling market orders, has forced a change of behavior from
banks, which have moved toward client profiling.
Dwindling volumes and fewer banks making markets have
shriveled the equity liquidity base, which is where algorithms
help, because they allow investors
to find the other side of the trade. Algorithms also provide
for cost-effectiveness. Electronic trades cost nearly half the
amount charged by traditional brokerages.
investors mourn the loss of relationships with the
sell-side equity brokers. We see more and more young
graduate types on sales desks, says one trading head at a
buy-side firm. They are more groomed to understand the
electronic stuff, and maybe if they have enough personality
they can speak to clients too and cultivate
relationships, he says. But you have lost the
history of the relationship.
Do human traders still have a hope for connections, or has
the industry moved into a Its not you; its
me situation? Traditional sales traders can indeed
technological revolution but will need to build out their
electronic trading skill set and combine it with their
You now need sales traders to be experts across a much
wider range of capabilities, says Paul Squires, head of
trading at AXA Investment Managers in London. You have
the two extremes: the IT engineer, who can tell you all about
the algorithm, and the traditional sales trader, who has lots
of banter but little idea about algorithms. The optimal for us
now is someone who can do both.
And in fact the number of sales traders has rebounded
somewhat after the financial crisis. Back in 2000, when
algo trading started, many commentators were quick to predict
the death of the sales trader, says Richard Balarkas,
managing director at Quendon Consulting in London. That
simply hasnt happened. There may be fewer of them, but
many buy-side firms still see the sales trader as pivotal to
their broker relationship.
Balarkas is an electronic trading pioneer. During the late
1990s he set up Credit Suisses electronic and algorithmic
equity trading platforms. He says that machines arent
all-encompassing, at least not yet. Computers cant handle
nor are algorithms useful for dealing with big block
trades. Certainly they dont provide investors
with nuanced opinions on the market. And many buy-side firms
are suspicious about dealing with high frequency traders.
These guys seem to make money every day, says
Jeffrey Knight, head of global asset allocation at Columbia
Management Investment Advisers in Boston. The recipe is
to extract profits from every trade. It does seem that there
can be the amplification of trends, like the
flash crash [of May 6, 2010], because of HFT.
Many banks have already been merging their sales trading
desks with their pure trading operations to create execution
advisory desks. The sales traders in turn are becoming a new
hybrid of market specialists.
And Lewiss tempest in a teacup might already have
blown over. Figures from New Yorkbased Tabb Group show
that U.S. HFT profits have declined steadily, from $7.2 billion
in 2009 to $1.1 billion last year. (Projections for 2014 from
Tabb do show revenues ticking up slightly this year, however,
on the back of increased volatility and volume, to $1.3
billion.) Similarly, the HFT share of equity trades has
dropped, from 61 percent in 2009 to 49 percent in 2013 in the
U.S. and from 38 to 25 percent in the EU.
The broader issue of electronic trading, however, isnt
going away. According to Tabb, 96 percent of institutional
investors want to increase the algorithmic flow, whereas the
remaining 4 percent want to increase their sales trading
capabilities. Although this doesnt necessarily herald a
revival in the sales trader, maybe the machines havent