Quick follow-up to yesterday’s post.
Everyone thinks of HFT (“the algos” as the desk used to call it) as a monolithic industry. I’ve always argued that HFT is a strategy employed by algorithmic trading firms rather than a category of firm. HFT strategies used to be the providence of a few Chicago prop shops, but has now spread throughout the industry.
David Light, in a commentary on his blog, segments the new algo liquidity providers into two categories: short term and long term players.
Short Term Players. These are the ones that have made most of their revenue (early 2000′s to present) by classic gaming and latency strategies. … they take minimal intraday risk in the marketplace and go home “flat” after every trading session. These are the entities that most of the dealer community thinks of when speaking about HFTs/Algos. … Extracting small margins repeatedly many times a day has become increasingly more difficult for a host of reasons, the primary ones being increased competition among their brethren along with the prominence of dealer bilateral platforms which have made the public venues, … increasingly more crowded and toxic.
Long Term Players. These are the entities that are trying to seize the opportunity in the markets and are quietly arming themselves for future growth. These firms have sophisticated correlation models and commit capital on an interday and intraday basis. Like dealers, they can hold positions and have the luxury to be patient given their more formidable capital structure. A portion of their business is done through the traditional means mentioned above, however they realize that the profit potential is limited due to the numerous competitive pressures (mentioned above). … This enables firms with the technical sophistication and appropriate capital to achieve profits far behind the micro strategies of just playing within the UST market. … By consolidating with the short-term algo firms, they can increase their scope and simply attain much better economics of scale to feed their elegant market models.
David’s segmentation matches up with my conversations with industry professionals. The Short Term Players that are still using the same models from the 2005 US equity markets are getting crushed due to increased competition, increased sophistication of internalization, and a lack of volatility in the markets. They will consolidate, pull out of the more competitive asset classes, or close up shop.
The Long Term Players aren’t killing it due to the lack of volatility, but they are growing increasingly confident about their future as the new liquidity providers. They are investing in their operations to take advantage of the vacuum that the dealers have created. This new breed of liquidity providers will look nothing like the Flash Boys or dealer cartel of old.
