What follows is arecent blog post by Streetwise Professor Craig Pirrong, a market structure expert from the University of Houston, who dicusses the nature of cyclical market transitions. He remarked on seeral HFT-related stories – Virtus bid for KCG, Quantlabs buying HFT company Teza and Interactive Brokers exiting options market-making. What follows are Pirrong’s driect thoughts and musings.
No worries, folks: Im not dead! Just a little hiatus while in Geneva for my annual teaching gig at Universit de Genve, followed by a side trip for a seminar (to be released as a webinar) at ESSEC. The world didnt collapse without my close attention, but at times it looked like a close run thing. But then again, I was restricted to watching CNN so my perception may be a little bit warped. Well, not a little bit: I have to say that I knew CNN was bad, but I didnt know how bad until I watched a bit while on the road. Appalling doesnt even come close to describing it. Strident, tendentious, unrelentingly biased, snide. I switched over to RT to get more reasonable coverage. Yes. It was that bad.
There are so many allegations regarding surveillance swirling about that only fools would rush in to comment on that now. Ill be an angel for once in the hope that some actual verifiable facts come out.
So for my return, Ill just comment on a set of HFT-related stories that came out during my trip. One is Alex Osipovichs story on HFT traders falling on hard times. Another is that Virtu is bidding for KCG. A third one is that Quantlabs (a Houston outfit) is buying one-time HFT high flyer Teza. And finally, one that pre-dates my trip, but fits the theme: Thomas Peterffys Interactive Brokers Group is exiting options market making.
Alexs story repeats Tabb Group data documenting a roughly 85 percent drop in HFT revenues in US equity trading. The Virtu-KCG proposed tie-up and the Quantlabs-Teza consummated one are indications of consolidation that is typical of maturing industries, and a shift it the business model of these firms. The Quantlabs-Teza story is particularly interesting. It suggests that it is no longer possible (or at least remunerative) to get a competitive edge via speed alone. Instead, the focus is shifting to extracting information from the vast flow of data generated in modern markets. Speed will matter here-he who analyzes faster, all else equal, will have an edge. But the margin for innovation will shift from hardware to data analytics software (presumably paired with specialized hardware optimized to use it).
None of these developments is surprising. They are part of the natural life cycle of a new industry. Indeed, I discussed this over two years ago:
In fact, HFT has followed the trajectory of any technological innovation in a highly competitive environment. At its inception, it was a dramatically innovative way of performing longstanding functions undertaken by intermediaries in financial markets: market making and arbitrage. It did so much more efficiently than incumbents did, and so rapidly it displaced the old-style intermediaries. During this transitional period, the first-movers earned supernormal profits because of cost and speed advantages over the old school intermediaries. HFT market share expanded dramatically, and the profits attracted expansion in the capital and capacity of the first-movers, and the entry of new firms. And as day follows night, this entry of new HFT capacity and the intensification of competition dissipated these profits. This is basic economics in action.
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Whether it is by the entry of a new destructively creative technology, or the inexorable forces of entry and expansion in a technologically static setting, one expects profits earned by firms in one wave of creative destruction to decline. Thats what were seeing in HFT. It was definitely a disruptive technology that reaped substantial profits at the time of its introduction, but those profits are eroding.
That shouldnt be a surprise. But it no doubt is to many of those who have made apocalyptic predictions about the machines taking over the earth. Or the markets, anyways.
Or, as Herb Stein famously said as a caution against extrapolating from current trends, If something cannot go on forever, it will stop. Those making dire predictions about HFT were largely extrapolating from the events of 2008-2010, and ignored the natural economic forces that constrain growth and dissipate profits. HFT is now a normal, competitive business earning normal, competitive profits. And hopefully this reality will eventually sink in, and the hysteria surrounding HFT will fade away just as its profits did.
The rise and fall of Peterffy/Interactive illustrates Schumpeterian creative destruction in action. Interactive was part of a wave of innovation that displaced the floor. Now it cant compete against HFT. And as the other articles show, HFT is in the maturation stage during which profits are competed away (ironically, a phenomenon that was central to Marxs analysis, and which Schumpeters theory was specifically intended to address).
This reminds me of a set of conversations I had with a very prominent trader. In the 1990s he said he was glad to see that the markets were becoming computerized because he was tired of being fucked by the floor. About 10 years later, he lamented to me how he was being fucked by HFT. Now HFT is an industry earning normal profits (in the economics lexicon) due to intensifying competition and technological maturation: the fuckers are fucking each other now, I guess.
One interesting public policy issue in the Peterffy story is the role played by internalization of order flow in undermining the economics of Interactive: there is also an internalization angle to the Virtu-KCG story, because one reason for Virtu to buy KCG is to obtain the latters juicy retail order flow. Ive been writing about this (and related) subjects for going on 20 years, and its complicated.
Internalization (and other trading in non-lit/exchange venues) reduces liquidity on exchanges, which raises trading costs there and reduces the informativeness of prices. Those factors are usually cited as criticism of off-exchange execution, but there are other considerations. Retail order flow (likely uninformed) gets executed more cheaply, as it should because it it less costly (due to the fact that it poses less of an adverse selection risk). (Who benefits from this cheaper execution is a matter of controversy.) Furthermore, as I pointed out in a 2002 Journal of Law, Economics and Organization paper, off-exchange venues provide competition for exchanges that often have market power (though this is less likely to be the case in post-RegNMS which made inter-exchange competition much more intense). Finally, some (and arguably a lot of) informed trading is rent seeking: by reducing the ability of informed traders to extract rents from uninformed traders, internalization (and dark markets) reduce the incentives to invest excessively in information collection (an incentive Hirshleifer the Elder noted in the 1970s).
Securities and derivatives market structure is fascinating, and it presents many interesting analytical challenges. But these markets, and the firms that operate in them, are not immune to the basic forces of innovation, imitation, and entry that economists have understood for a long time (but which too many have forgotten, alas). We are seeing those forces at work in real time, and the fates of firms like Interactive and Teza, and the HFT sector overall, are living illustrations.
