The publication of Michael Lewis’ book Flash Boys early in 2014 brought high-frequency trading (HFT) to the attention of many investors for the first time.
Lewis was quoted on “60 Minutes” saying that HFT rigs the stock market against the small investor. Media made it known that the FBI – the folks who investigate drug dealers and organized crime – was investigating HFT.
Wenning Advice had posted frequently about the practice as early as 2011, warning about the distortion that high-frequency trading causes to market fundamentals, the predatory nature of high-frequency trading, the inequity of high-frequency trading, and the risk that high-frequency trading creates for all of us. We even pointed out that “Satan is a high-frequency trader.”
Michael Lewis
But what’s happened to HFT since 2014? And what happened to the FBI’s investigation of the practice?
HFT has not gone away. But it’s not what it used to be.
We noted in 2011 that HFT accounted for 73% of all equity trading in the U.S., up from 30% four years earlier, based on research from TABB Group.
Rosenblatt Securities estimated that HFT trading volume fell from about 3.25 billion shares a day in 2009 to 1.6 billion shares in 2012. And TABB Group estimated that HFT revenues from U.S. equity trading declined from about $7.2 billion in 2009 to $1.3 billion in 2014.
HFT Today
So what happened? Was Lewis’ book outdated even before it was published? Did the FBI catch the bad guys? Are new regulations keeping traders honest?
First, it’s important to note that HFT is still alive and well. Even if it has a smaller share of the U.S. equities market, there are other countries and other securities to trade in. While HFT in U.S. equities may have dropped off, TABB Group noted that in 2013 it accounted for about 61% of all futures-market volume, up from 47% in 2008.
Another factor affecting HFT is competition. It’s a crowded market and, Investopedia noted, “Individuals and professionals are pitting their smart algorithms against each other. Participants even deploy high-frequency trading algorithms to detect and outbid other algorithms. The net result is of high-speed programs fighting against each other, squeezing wafer-thin profits even more.”
As a result, Bloomberg reported in 2013 that, “Speed traders aren’t just trading fewer shares, they’re making less money on each trade. Average profits have fallen from about a tenth of a penny per share to a twentieth of a penny.”
If you’re trading a bazillion shares, a twentieth of a penny can still account for some serious revenue – but increasing competition and the need to invest in the latest and fastest technology have made it more difficult for HFT firms to be profitable. In addition, to succeed, because nanoseconds count in HFT, firms need to be as close as possible to exchange servers. There’s only so much real estate and those firms that are not strategically located near an exchange can no longer compete.
“A high-frequency trading program costs enormous amount of money to establish and maintain,” according to Investopedia. “The powerful computer hardware and software needs frequent and costly upgrades that eat into profits. Markets are highly dynamic, and replicating everything into computer programs is impossible. The success rate in high-frequency trading is low, due to errors in underlying algorithms which are implemented.”
Hold back your tears, though. We now we have ultra-high-frequency traders that pay for access to an exchange that shows price quotes a bit earlier than the rest of the market. This sounds a lot like the frontrunning that Lewis wrote about when he claimed that the markets are rigged.
Traders are also finding new ways to cheat. Automated news-based trading and social media feed trading are two examples.
In August, nine individuals, including two Ukrainian hackers, were indicted for making $100 million in illegal profits based on their access to hundreds of press releases from publicly traded U.S. companies before the press releases were made public.
HFT Indictments
Meanwhile, those “flash boys” who are operating outside the law are, in some cases, being indicted.
In the futures market, regulators are paying increasing attention to “spoofing,” in which traders bid or offer, but then cancel their orders before they are filled. It’s a case of the manipulators being manipulated, as the resulting activity is intended to attract other high-frequency traders to create a particular market reaction, such as manipulating the market price of a security.
High-frequency trader Michael Coscia, owner of the former Panther Energy Trading LLC, was the first to be indicted for spoofing by the FBI in October 2014. Spoofer Navinder Singh Sarao was recently imprisoned for his role in the 2010 “flash crash” and Bloomberg reported in September that federal prosecutors were expanding their probe of alleged spoofing by Igor Oystacher, co-founder of the proprietary trading firm 3Red.
In January, the FBI arrested a Russian spy who was looking into how to bring down the U.S. financial system using HFT (isn’t Russia the country that’s helping us fight ISIS in Syria?).
And then there’s the case of Latour Trading, which at times accounted for 9% of all U.S. stock trading, according to the U.S. Securities and Exchange Commission (SEC).
A year ago, in its first enforcement action against a high-frequency trading firm, the SEC charged Latour Trading with “using faulty calculations in complex trading strategies that let it buy and sell stocks without holding enough capital,” according to Zerohedge.
Latour didn’t admit or deny wrongdoing, but agreed to pay $16 million to settle the case.
But then last week Latour was found to have violated other SEC rules – in this case the market access rule and regulation national market system – over a period of nearly four years during which Latour sent millions of non-compliant orders to U.S. exchanges.
This time Latour was charged with a $5 million penalty and will be forced to repay more than $3 million in profits that resulted from the regulatory violations.
So high-frequency trading has not gone away. Given the amount of money that flows through Wall Street, HFT – or variations of it – will always be with us.