High-frequency trading, which already accounts for about two-thirds of U.S. equities volume, is a growth industry. That, at least, is the consensus of a half-dozen executives in the high-frequency trading arena.
John Netto, president of M3 Capital, a proprietary trading firm that operates mainly in the futures markets, said at a recent panel discussion that capital efficiency and operational efficiency make high-frequency trading strategies in a range of asset classes attractive to many firms. These strategies typically don’t require large outlays of capital, he said, because positions are held for short durations and "overnight risk is really frowned upon."
Advances in computing power have boosted the ability of firms to take advantage of pricing inefficiencies in various markets, Netto said. And changes in who provides liquidity to the markets, he suggested, have opened the doors to high-frequency firms.
The M3 executive, along with five other trading industry pros, spoke last Wednesday at a Thomson Reuters panel about high-frequency trading. The panel was moderated by Rich Brown, global business manager for machine-readable news at Thomson Reuters.
Brian Tahan, a vice president in the Advanced Execution Services group of Credit Suisse, stressed that high-frequency trading has been around for a while. Its current incarnation, he said, came about as a result of enhancements in technology and, on the regulatory front, decimalization and Regulation NMS.
Changes that took place in the mid-to-late 1990s, he said, have "come to a head right now," with the prevalence of high-frequency trading strategies. He added that there is now "increased demand for talent in this space," especially programmers and those with a track record developing models for automated trading.
Dhiru Patel, chief quantitative strategist at Thomas Weisel Partners, agreed. Changes in the regulatory environment, advances in technology on both the sellside and at exchanges, and decimalization have "generated an arms race" to build high-frequency trading strategies, he said.
Emmanuel Doe, global business manager for the tick history archive at Thomson Reuters, added that more high-frequency trading funds are now launching, along with high-frequency trading groups within larger funds. "Assets are starting to migrate" to these strategies, he said, in part because some of these funds have a lower tolerance for risk than they previously had.
All of the panelists hailed the liquidity added to the marketplace by high-frequency trading firms. They noted that this has made the markets more efficient. There are "enough diversified market participants to pounce" on any inefficiencies in the market now, Thomas Weisel’s Patel said. He also suggested that high-frequency trading "may be considered a traditional way of trading" five years from now. It could be "like algos a few years ago," he said. Algos are now a common way to trade stock in the current fragmented marketplace.
The panel’s audience, however, was less sanguine about the benefits of high-frequency trading. Asked if the growth of high-frequency trading might produce new risks and execution problems for fund managers implementing algorithmic strategies, most audience members said yes. Forty percent said it could be a problem. Another 30 percent said it could be a huge problem that might prompt the "exodus" of buyside trading to other venues–presumably to dark pools and upstairs desks.
Another 16 percent said it was not a big concern, while 14 percent said it would produce either no or only insubstantial concerns. Close to 200 people attended the Thomson Reuters event, with the vast majority indicating that they were not currently engaged in high-frequency trading. (About 110 people answered the audience poll questions.)
This panel took place against the backdrop of increased focus on high-frequency trading. The Securities and Exchange Commission is gathering more information about assorted high-frequency strategies and whether trading practices by these firms may affect intraday volatility and other market factors.
In an effort to fuel a broader understanding of the "high-frequency trading" umbrella phrase, the panelists offered their own definitions about what constitutes this type of trading. High-frequency trading involves any strategy "that takes advantage of market inefficiencies of really short durations," such as a couple hundred microseconds, said Patel of Thomas Weisel. The typical goal is that these strategies will end the day "flat, with some positive P&L," he said. These strategies could include statistical arbitrage, market making or pure proprietary trading, he added.
M3 Capital’s Netto said high-frequency trading involves strategies involves "many variations, including looking for small price anomalies in multiple correlated markets and using superior data processing and technology to take advantage of them."
Credit Suisse’s Tahan said the basic characteristics of high-frequency trading firms include "high sensitivity to latency, high sensitivity to cost." These firms, he said, are also "major consumers of [market] data."
Several panelists de-emphasized speed as an end in and of itself. Eric Karpman, director of Luxoft Trading Systems, a consultancy that creates trading technology for high-frequency strategies, reminded the audience that while speed is often important to high-frequency trading firms, and has been the focus of recent attention about high-frequency strategies, it’s "not the speed that we’re after but the results."
In a liquid market like U.S. equities, which is extremely efficient, he said, speed may have to be measured in milliseconds or microseconds to generate the results these firms pursue. But in other markets, Karpman said, speed could be measured in "seconds or minutes, and you’re still ahead of everybody else." He stressed that the focus of these strategies is not absolute speed but the ability to profit from inefficiencies in a particular market.
Todd Hazelkorn, the lead financial engineer at Infinium Capital Management, agreed. High-frequency trading often involves processing a lot of information, he said, but doesn’t have to take advantage of the "lowest latency possible" to be successful. He told the audience that even "if you’re not the fastest, [that] doesn’t mean you can’t participate."
High-frequency trading in U.S. equities is dominated by firms such as GETCO, Tradebot Systems, Citadel, Automated Trading Desk (a subsidiary of Citi), Lime Brokerage and several others, according to Rosenblatt Securities. Rosenblatt recently published a 30-page detailed report on the history, characteristics and impact of high-frequency trading. The report noted that the growth of high-frequency trading generally both influences and is influenced by market structure changes in the U.S. and elsewhere.
Luxoft’s Karpman said his firm’s main challenge is competing against bigger players. It’s hard, he said, to compete with large firms that invest many millions of dollars in technology.
But smaller firms can also benefit from broker-dealers and others servicing the growing arena of high-frequency trading firms, panelists observed. Brokers and technology services firms can "host" a smaller firm’s access to exchanges and meet some of the trading infrastructure needs of these clients.
Credit Suisse’s Tahan noted that "there’s no question that there’s a big spend" among bulge-bracket firms and others able to spend millions of dollars on the technology infrastructure that enables them to conduct automated trading. A lot of computing power, he said, is required to take in the vast amount of equities market data from multiple sources that’s needed to fuel quoting models. He added that broker-dealers can help firms establish market connectivity, provide access to dark pools, and offer smart routers and algorithms.
