“It’s like a perfect storm. The cheats are going away, the volatility is going down and the costs are going up.”
Haim Bodek, former head of electronic volatility trading, UBS AG
You could conclude, as Credit Suisse has in a new report, that high-frequency trading is so influential, it “has reshaped the financial industry in its image.”
Or you could conclude, as The Wall Street Journal has, that high-frequency trading is a failing niche on Wall Street.
High-frequency trading uses algorithms and technology to make trades at mega-fast speeds to take advantage of price inefficiencies. Author Michael Lewis brought public attention to high-frequency trading when he published his book Flash Boys in 2014, which claimed that the stock market is rigged.
We’ve railed against HFT as far back as 2011, noting that the majority of trades taking place were being driven not by company performance, but by “tiny inefficiencies that only computers can detect.”
At the time, HFT accounted for 73% of all equity trading in the U.S., up from 30% four years earlier, based on research from TABB Group.
By 2016, though, high-frequency trading accounted for just under half of all stock trading. That was about even with the previous three years, but more than double what it had been in 2006, Credit Suisse noted.
Revenues Down 85%
The more interesting stat from TABB Group, though, was in The Wall Street Journal article, which noted that revenues from U.S. equities trading at HFT firms were only about $1.1 billion last year, down from $7.2 billion in 2009.
An industry wide drop in revenues of nearly 85% is not a good sign. So why have the flash boys lost their flash?
Lower volatility. Market making, a core HFT strategy, depends on rapidly buying and selling large volumes of stock and profiting from the small price difference. But such strategies work best when the market is volatile – and lately, it hasn’t been.
The CBOE Volatility Index (VIX) has averaged just 11.6 this year, down from 24.2 in 2011, according to the WSJ Market Data Group. Of course, the level of volatility could change at any time, but for now less volatility means high-frequency traders aren’t flying as high.
Rising costs. High-frequency trading is like gun-slinging in the Wild West – the fastest draw wins. To beat the competition, high-frequency firms must also be high-speed firms. With nanoseconds making a difference, many firms replaced their fiber-optic cable systems with microwave networks. Now some are upgrading further to millimeter-wave and laser technology.
High-frequency trading firms also purchase data from the New York Stock Exchange and Nasdaq Inc. and others and costs have increased as the industry has grown. In a letter to the Securities and Exchange Commission last year, Wolverine Trading LLC of Chicago said its expenses for market data from the NYSE had more than tripled from 2008 to 2016.
“This is a monopoly,” Wolverine said in its letter. The writer may not have seen the humor in a high-frequency trading firm claiming that the NYSE is pursuing unfair business practices.
More competition. As the industry grew, more companies jumped in, which is not surprising, given that companies could make money without taking much risk. As profits dropped and costs rose, the industry has consolidated and some companies have left the business altogether.
Earlier this month, Virtu Financial Inc., one of the biggest electronic traders, sought to acquire KCG Holdings Inc., another major player in the industry. Virtu’s stock price has been dropping and KCG has been losing money.
Meanwhile, Teza Technologies announced that it is leaving the business and Interactive Brokers Group Inc. is ending its options market making activities.
The most successful companies that are still in the business have diversified into currencies, commodities, foreign equities and other asset classes.
We’re all high-frequency traders now. So says, Credit Suisse, noting that the rest of Wall Street is seeing much higher overall trading activity and there is now a bias toward parts of the market that are easiest to trade with high-frequency strategies.
The Credit Suisse report says that total U.S. trading volumes today are “more than double what they were in the pre-crisis, largely pre-HFT years.”
What FBI Investigation?
As a footnote, after the release of Flash Boys, the FBI announced that it was launching an investigation of high-frequency trading firms. Google “high-frequency trading” and “FBI investigation” and you’ll find dozens of stories in financial media from 2014 about the FBI’s investigation … and not a word since then.
We can conclude that: 1. Both the media and the FBI have short attention spans, and 2. High-frequency trading wasn’t going to bring Director James Comey enough headlines.