High-Speed Trading Slowing Down
With stock market volumes and volatility down, high frequency trading is moving onto greener pastures, both geographically and in terms of asset classes.
It’s not easy being a high frequency trader these days.
Market volume is down and market volatility has largely vanished, making it ever harder for the high-speed trading crowd to employ their blindingly quick and often repetitive “buy and sell” strategies on U.S. and European markets and reap a healthy profit.
And while the push for speed can be prohibitively expensive — with some signing up for the fastest possible fiber optic, microwave or chip technology — others see the beginning of the end of the high-speed advantage, as a growing universe of traders uniformly achieve the fastest speeds.
Combine that with heightened scrutiny by regulators in the U.S. and Europe and the possibility of new trading restrictions, and HFT traders have a lot of worries on their minds these days.
So what’s a competitive HFT trader to do?
For some, the answer has been to exit the market entirely. “We’re in the middle of a shakeout, where a lot of people have poured a lot of money into this [high frequency trading] and are now realizing that it’s not the gold mine they expected,” says Charles Jones, a professor of finance at the Columbia Business School and consultant to Citadel, a Chicago-based hedge fund, institutional trading firm and well-known practitioner of HFT strategies.
Jones says that he has seen a considerable number of small HFT firms — “two guys and a Bloomberg machine” — exit the scene or simply pare back their HFT efforts.
Larry Tabb, CEO and founder of research firm, TABB Group, is more specific: “Profitability for high frequency traders has been down fairly significantly for the last three or four years.” His firm reports that HFT profits in U.S. equity markets dropped from $7.2 billion in 2009 to a projected $1.8 billion in 2012, while over the last two years, HFT as an overall percentage of U.S. equity volume has dropped slightly from 56 percent in 2010 to a projected 53 percent in 2012.
In the U.S., the activity has also been stifled by the pending Volcker Rule, which restricts commercial and investment banks from proprietary trading that does not directly benefit their customers. In November of 2011 Bank of America sold its high frequency trading operations to Getco, a major HFT firm.
Nikoleta Panteva, a senior analyst with research firm IBISWorld, reports that greater regulatory scrutiny has also brought with it the need for HFT traders to spend significantly more on surveillance technology to ensure that their activities are not abusive to the market or illegal in any way, and it is possible the costs will rise in the months ahead. She notes that surveillance costs were an estimated 26.5 percent of revenue in 2012.
But for those HFT traders that aim to stay in the game, experts and market watchers say that the race is on for them to shift their focus to an ever widening array of asset classes as well as a far broader swath of global markets, where HFT activities are far more welcome, the strategies are far less familiar and the speed and infrastructure requirements are less punishing from a price perspective.
“There is a push to go into other asset classes, most notably foreign exchange, and we even see some high frequency traders moving into the U.S. Treasury market; they are really trying to look around,” says Tabb. Notes James Angel, a professor at Georgetown University who specializes in the study of the structure of financial markets, high frequency traders have moved far beyond cash equities of late and have brought their strategies to the derivatives arbitrage arena, the currency markets, commodities and everything else.
“As it’s become harder for high frequency traders to make a profit, they’ve started to look elsewhere, far beyond U.S. equities,” Angel says.
Coupled with the current push into new asset classes has been a flow by HFT traders into new, global markets. HFT adviser Jones notes that once HFT code is written, it is fairly easy to port that over to another market. “Their structures are fairly similar and many of the global exchanges are using the exact same software,” Jones says.
Jock Percy, CEO of Perseus Telecom, a Dublin-based provider of ultra-low-latency telecom systems and trans-Atlantic connectivity to exchanges, notes that among his customer base, HFT traders are increasingly seeking high-speed connectivity between Chicago and Sao Paulo, London and Moscow and the U.S. or U.K. markets and Asia, with Korean markets attracting a high amount of attention as the highest ranking futures exchange by number of contracts.
“We see traders actively seeking global markets with wider spreads, more liquidity and the ability to compete with traders who don’t have expertise in HFT strategies,” Percy says.
Bob Fuller, chief administration officer with Fixnetix, a London-based provider of ultra-low-latency trading technology that recently helped the London Metals Exchange switch from open outcry to an electronic format, points out that the definition of high frequency trading in some Asian markets is quite different than the definition elsewhere. This presents an opportunity for experienced HFT traders who may not have the fastest trading capabilities to successfully employ their strategies in these newer, somewhat slower HFT trading arenas.
“The Tokyo exchange is now the fastest in the Far East and others will soon adapt, bringing much lower latencies to Asian markets,” Fuller says.
Still other observers point to a growing shift among HFT firms away from speed, as the costs to compete remain prohibitively high while the opportunity for speed enhancements dwindles.
“The arms race that has been a fixture of high frequency trading for many years is basically coming to an end,” says Manoj Narang, CEO and founder of Tradeworx, an HFT trading firm and technology provider. “Now that profits are declining for many HFT firms, they are jettisoning their R&D activities and starting to outsource their technology activities.”
Researcher Tabb agrees, noting that “the market is moving away from speed,” while the investment that is needed to keep up with the biggest and fastest players has overwhelmed the profitability of some HFT strategies. “We are seeing many smaller players move into strategies that are far less speed oriented, such as pairs trading or the development of analytical models to assess what prices are versus what they should be, compared to other factors in the market.”
Similarly, consultant Jones says that with the speed game slowing down, some high-speed traders are thinking about the greater use of or refinement of signals beyond price changes, including sentiment analysis or the assessment of social media communications about public companies on networks such as Twitter, Yahoo and Facebook. They are also looking at the use of artificial intelligence or intelligent software agents to automate and speed up the process of filtering and assessing the ever-growing fire hose of sentiment data.
Narang of Tradeworx says that on the strategy front, he sees the convergence of high frequency trading strategies that frequently employ what he calls “structural correlations” — for example, the correlation between S&P 500 futures and the SPY ETF prices that are easy to model but require great speed and quick action to exploit — and the sort of statistical arbitrage modeling approaches usually associated with established hedge funds. According to Narang, the latter involves the exploitation of price discrepancies among securities that tend to be far more difficult to model, in part, because the models vary over time, require greater holding times and in turn, are not dependent on speed for execution.
“Speed has mattered more for structural correlations while quantitative skills mattered more for statistical correlations, but these two kinds of firms are now eating each other’s lunch,” Narang says, as he sees HFT firms gaining more expertise in the latter skill and taking longer term bets while, in turn, traditional hedge funds have become more adept at strategies usually associated with high frequency trading.
Irene Aldridge, an HFT trader, consultant and managing partner at Able Alpha Trading, says that on the strategy front, she sees heightened interest in the latest iteration of short term forecasting tools and quantitative analysis that allows traders to exploit small price moves in a wider array of markets. She says this was a major theme at a recent quant conference where representatives from Citadel, Quantitative Brokers and Morgan Stanley were in attendance.
With challenges such as these facing the HFT arena, one wonders if there are any benefits in these developments for institutional investors and others who have raised questions about the impact of HFT trading on markets. According to Tabb, while he knows that many institutional investors would like to see a reduction in HFT activity, the problem is that this would ultimately mean far less liquidity in the market. His final assessment: “Fewer high frequency traders in the equity markets would mean a less healthy market for everyone.”