High Fixed Costs

The Difficulty of Scaling an Algo Trading Business to the Opportunity

Wall Street firms over-hire in the boom times and over-fire in the busts. Investment banks in particular are designed around having low fixed costs (infrastructure, base salaries) and high variable costs (bonuses, risk capital allocation). If the market opportunity is low then a bank can lower bonuses, fire people, and/or reduce balance sheet quickly. If the market opportunity is high then banks will overpay to bring in the right people and allocate risk capital to its most productive uses.

Most of the value in a sales & trading operation at a bank is created by the salespeople and traders. These people require very little effort to spin up and turn down as market opportunities appear and go away. Another way of saying this is that there is very little enterprise value in the bank. Not coincidently, this is why a bank’s stock price is based on its book value and not an earnings multiple like a technology company.

Algorithmic trading shops are a very different animal. They have very high fixed costs. The infrastructure to compete only gets more expensive every year. You even have to build your own microwave network across the Appalachians and Northern Europe!

The people in an algo shop are also expensive. HFT developers have a much higher base (thanks to competition from the technology sector) and a lower bonus multiple then sales/trading. Their job also requires them to have a tremendous amount of institutional knowledge. It can take months for a developer to be productive so you can’t just hire and fire easily like a trader.

Algo trading firms are simply unable to scale their businesses when low opportunity periods persist. Firms either have to eat loses, shut, sell themselves, or close down entire areas of trading. Which brings us to this week’s round of news:

Profitability across the industry is estimated at $1.3B and is being spread among more and more firms. We’re going to see more of these merges/sales/closes in the next year as space continues to consolidate. The Flash Boys will look very different in the near future.

Edit: I posted a follow-up on January 28th, 2015.

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