Sorry, But High-Frequency Trading Is Not Dead

“To succeed, jump at opportunities as you do at conclusions.” — Benjamin Franklin

Analysts nowadays try to convince us that the financial markets have changed in a way that they are now the perfect environment for mom-and-pop investors. The main villain, in the face of high-frequency traders, is gone and our markets are back to their hyper-ultra-efficiency. Transparency, equal-for-all market rules, unharmed profits opportunities, lack of hidden costs — everything in the garden is rosy. Until it isn’t.

We’ve been here before

The financial sector loves its periodical obsessions. First, it was the dot-com bubble. It burst and some companies went bankrupt. Others, such as eBay, Amazon, and Cisco survived. Not to mention Amazon’s current valuation, these businesses went on to become some of the most successful in history.

Then came the credit derivatives which lead us to the biggest financial crash since the Great Depression. Some banks and insurance companies went bankrupt. The biggest players survived and continued to run the industry. Does it seem today that they have given up trading credit derivatives? All the regulations may have reduced their amount, but there is still a $10 trillion CDS market.

Now replace the dot-com bubble and the credit derivatives with high-frequency trading and the picture won’t change much. Speed bumps leading to reduced performance and shrinking profits, higher trading costs, market consolidation, pressure from the regulators — so many obstacles, yet the main players in the HFT industry are still here. The perception that they are some stunted business structures which can’t adapt and will soon become obsolete is just wrong. The truth is that high-frequency trading is here to stay.

The picture today

As of now, it is only 10% of all trades that are executed the old-school way — via regular stock picking. The rest is automated trading. Currently, high-frequency trading is responsible for 50–60% of all trading activity. If we take a look at HFT’s trading volume as a percentage of the total stock trading volume during the last decade in the US, then things don’t change much. In fact, it has never fallen below 50%.

“Total US volumes today, however, are more than double what they were in the pre-crisis, largely pre-HFT years. The difference is mainly due to HFT and high-speed trading strategies.”
“We Are All High-Frequency Traders Now”, A note by Credit Suisse

It is quite clear that even MiFID II and FINRA’s rule on algorithmic trading didn’t do much in regard to minimizing the high-frequency trading activity.

The dawn of an industry. Or is it?

It is an undeniable fact that the industry is not booming and the profits are not peaking as it was the case a decade ago. This was the reason why some analysts went on to say their goodbyes to HFT, which in all aspects, is simply too premature. But taking the information out of context, without acknowledging the details behind the current state of the industry, simply means to intentionally paint a misleading picture.

The rise of High-Frequency Trading for the period 2007–2012. Source: Nanex.

The details:

  • Most HFT companies are privately-owned

Making conclusions about the faith of a whole industry based on the results of a few publicly-traded companies provides no valuable information and obviously deceives the audience. The truth is that most HFT companies are privately-owned, hence they don’t reveal any financial or operational information. In a niche industry like the high-frequency trading one, these prop shops are focused on retaining their secrecy and avoid revealing any details, relevant to the way they operate and their performance to the wide public.

Even if we do take a look at the publicly-traded Virtu, one of the leading players in the niche, and their latest financial results, it is clear that there is no such ‘’Doomsday scenario” as it is widely proclaimed. For 2017, the total revenue of the company increased with 45.8%, topping $1 billion, compared to $702.3 million a year before. For Q1, 2018, the firm’s net income saw an increase of 1845% with EPS of $1.86, crushing Wall Street’s estimates of $0.61. For the same quarter, its total revenues popped 453%. Clearly, no signs of a company that is about to quit.

  • The performance of the VIX

High-frequency trading companies are not some isolated ventures that operate in a vacuum. Although they are able to influence markets in some way, they are also very dependable on the market conditions as well. Due to the fact that most of the high-frequency trading strategies are based on taking advantage of price discrepancies, the higher the volatility is, the higher the number of trading opportunities they will have.

With that said, it is important to take a look at the performance of the VIX. In the last few years, it has hit the lowest levels since the pre-crisis period. And calm markets are not the best environment for the high-speed traders. High-frequency trading companies flourish in periods of high volatility. That is one of the main reasons why, currently, it is very hard for new companies to enter the market.

CBOE’s VIX for the last 10 years. Source: thinkorswim®
  • A hostile industry

The business, in its core, does not set boundaries to how much and how frequently a company can trade. Thus, the players with better algorithms, faster execution and more money at their disposal can basically overtake a significant part of the market. This limits the opportunities for new companies, as well as the boutique ones, which cannot keep up with the pace of the industry leaders. The competitiveness of the niche, in addition to the recent regulatory developments and the current market environment, has led it to the only logical step — consolidation. Those who were unable to bear with the increasing operational costs and investments in infrastructure couldn’t survive and left the market. Others were bought from the strongest players in the industry. Such “survival of the fittest” scenario reshaped the niche and highlighted a few leading companies that are about to run the show from now on.

Another reason why many HFT companies failed was their inability to keep up with the ever-increasing fees, collected by exchanges. A major part of these trading venues’ profitability comes from the sales of data feeds and collocation services to high-frequency traders. According to Wolverine Trading, a leading prop trading company, the costs of the fees they were paying for using NYSE’s market data rocketed 700% for the last 8 years. FT points out that the monthly fees that exchanges charge for using their services are usually in the range of $10 000 — $22 000 per connection.

Such fees are simply too high for the smaller high-frequency trading companies. This makes some of them head for an early exit, while others are merging with their competitors in order to form more powerful ventures. In a niche industry like the high-frequency trading one, a scenario like this is more than reasonable.

  • Pressure from the regulators

Although with a small delay, the regulatory authorities introduced measures to limit the effect of harmful high-frequency trading activities. MiFID II in Europe and the FINRA’s rule on algorithmic trading in the US were designed with the idea to bring a much-needed transparency and reduce the predatory practices on financial markets.

The MiFID II, for example, examines high-frequency trading as a subset of algorithmic trading. The oversight framework requires those investors, who are involved in high-speed trading to keep hold of their time-sequenced records and trading systems for the last 5 years at least. This oversight requirement is intended to tackle one of the high-frequency traders’ most preferred strategies — the process of sending a large number of orders with the only intention to cancel them before execution, also known as “spoofing”.

The case is the same when it comes to the Asia-Pacific region. In March 2010, a Technology Advisory Committee was set up in India with the main goal to advise on the matter of high-frequency trading. A few months later, in Australia, the local Securities and Investment Commission issued a consultation package intended to examine all the pros and cons of HFT.

Although the regulatory approach to high-frequency trading was individually-tailored to the specific characteristics of each market, a clear definition of the harmful high-speed trading activities and exact measures to identify them were still missing a while ago. With the issuance of the new regulatory package by the European Securities and Markets Authority (ESMA), we now have a clearer description of high-frequency trading activities. High-speed traders are identified on the basis of two main characteristics:

- Quantitative thresholds

- Comparison between median order lifetime and the median lifetime of all orders in the certain trading venue

The lack of specific rules and regulations before the introduction of MiFID II and FINRA’s rule on algorithmic trading allowed high-speed traders to churn excessive profits that are currently being significantly minimized.

High-frequency trading is going nowhere

The truth is that there is no going back. Algorithmic trading, a large part of which is HFT, is here and will remain so in the near future. For the last decade, it has become an invariable part of the market structure. HFT is now a part of the market’s DNA. High-frequency traders are regarded as market makers, which at the same time, turn out to be exchanges’ biggest and most valuable clients. Without the high-frequency traders’ payments for collocation rights and data feeds, exchanges will need to increase their fees for the rest of their customers, in order to compensate to the lost profits. The effect will be transmitted through the whole chain and will result in increased trading fees for mom-and-pop investors.

  • Exploring new markets

Speed bumps and new regulatory frameworks may force high-frequency traders to slightly reshape their strategies, but their overall business model will remain pretty much unchanged. Speed will remain one of their most important assets and investments in infrastructure won’t stop. What we can expect to witness is a slight change in their targets. High-frequency traders are now seeking new ways to make money and cut costs. One of the possible ways to do that is turning their focus to emerging markets where new businesses are constantly welcomed. The BRICS, for example, is a very big market that is hungry for technology and a fresh breath of new businesses. On top of that, a big part of these countries does not have any stamp taxes, which allows high-frequency traders to cut costs and significantly optimize their performance. India, for example, in the last few years saw a significant boom in algorithmic trading. As of now, on the Bombay Stock Exchange, for example, more than 30% of all trades are executed algorithmically, while on the National Stock Exchange, the figure jumps up to 46%. These figures show that the market there has a very big growth potential.

  • Exploring new instruments

High-frequency traders base their growth strategies not only on penetrating new markets but on trading new asset classes as well. In the last few years, cryptocurrencies have become the perfect niche for high-speed traders to flourish as they are the most volatile investing class. Opposed to the opinion that HFT cannot be applied to cryptocurrency trading due to the longer transaction confirmation times on the blockchain, the things are starting to change.

HFT may enter the highly-volatile world of cryptocurrencies

Earlier this year, Coinbase, one of the most popular cryptocurrency exchanges and among the 10 biggest by trading volume, announced that it is about to upgrade its platform in order to allow traders to match buy and sell orders way quicker. Apart from that, the exchange revealed that it is going to lower the latency of its systems’ performance significantly so that it can speed up the trade execution time. Coinbase announced also that it is now offering their investors the chance to locate their servers in specifically-designed new premises in Chicago. By getting the chance to be as close as possible to the exchange’s matching engines, high-speed traders will basically replicate the collocation process that they are taking advantage of when trading on regular stock exchanges.

  • The industry’s interconnectedness

The high-frequency trading industry is not an isolated one. It is served by companies in many different fields, like construction and planning (for infrastructure projects and building fiber-optics traces), hardware manufacturers (for microchips and tools for optimizing the trade execution process), exchanges (data feeds and collocation rights) and others. This means that high-frequency trading is not only an integral part of the market structure, but it is also a well-developed industry with a long history and an established way of operating that is hard to be neglected. And just like each business niche, it has its own highs and lows.

It Remains a threat

If we were on the brink of the industry’s breakdown, why will we continue with the efforts to limit the high-speed trading activity? In the last few years, there were plenty of different measures, employed from both, private companies and regulatory authorities, to mitigate the high-frequency trading’s effect on the market.

  • The atomic clock

Renaissance Technologies, one of the most successful and secretive funds, filed an application for a patent on an atomic clock. But what makes Jim Simons, one of the industry brightest minds and a former code breaker for the NSA, and his highly successful company decide to spend time and money on getting such a patent? If the HFT technology was on its deathbed, why would a company that has constantly generated more than 40% annual gains after fees for the last 15 years through its Medallion Fund, require patented atomic clocks for their order execution? The answer is — to avoid being front-run by high-speed traders.

Atomic clocks — currently, the world’s most accurate time and frequency standards. They are used in space exploration programs by NASA, as well as for GPS satellites.

Apparently, the risk of being front-run is concerning even for such a progressive industry leader like Renaissance. The idea behind the filed patent application (№ 14/451,356) is to allow the company to “execute synchronized trades in multiple exchanges” and to ensure protection for large orders. Through a set of algorithms, host of computer servers and atomic clocks, the orders will be synchronized to within a few nanoseconds.

The concept behind the invention is based on splitting a large order to a bunch of smaller ones. Each of them is combined with a certain execution time. They are then sent to servers, located as close to exchanges as possible. The atomic clocks then reach the execution time, assigned to each order, and each server places the sets of smaller orders in nanoseconds of each other, thus reducing the chance of high-speed traders exploiting the order flow and front-running others.

  • IEX’s success

The main idea behind the establishment of IEX, back in 2012, was to build a transparent and predatory-free trading environment. Since then, it is becoming one of the most popular venues worldwide with trading volumes steadily growing.

IEX’s Trading Volume. Source: IEX

What is more important here is the need of having a high-frequency traders-free place. If the industry was on a decline, the interest in IEX’s services and its advantages over other exchanges (such as the speed bump) would have never been this high.

IEX’s Market Share. Source: IEX

Conclusion

We want to believe that our markets are efficient. We want to believe that they do not have any loopholes and they are not exploited. We want to believe that prices are not manipulated on a regular basis. And all that in times when periodical flash crashes make instruments’ prices bounce up and down like a tennis ball. It’s good to believe in all this, but relying only on beliefs can’t do any good. Not in the world of high-frequency trading.


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