09.21.2017
By John D'Antona

The End of an Era?

Has the day of the high-frequency trader and his hyper fast strategies seen its last days?

Is it time to queue up “This is the End” by the 1960s band The Doors? Or is more akin to February 3, 1959, when rock and roll musicians Buddy Holly, Ritchie Valens, and J. P. “The Big Bopper” Richardson were killed in a plane crash near Clear Lake, Iowa, becoming colloquially in then zeitgeist “The Day the Music Died?”

Well the “music’ didn’t exactly die, as Don MacLean sang but it did change. And likewise, HFT trading hasn’t necessarily died either despite some prognostications and hopes. Rather, it has evolved to survive in a slightly different iteration. Market forces, such as low volatility, thinner profit margins and an industry that has caught up technologically have all contributed to the morphing of HFT.

It has been no secret that for years high-frequency traders and strategies were making billions via their myriad hyper-fast low-size executions. But now that volatility has gone to the sub 10 level as measured by the VIX, the cost of technology itself has cheapened and the brokers have caught up in terms of technology spend, the playing field has leveled off.

The Day the Trade Died

Market volatility as measured by the VIX, has skidded two months in a row (as of this writing) to hit an all-time low. It was reported that in July 2017 the VIX average close was 10.3, decreasing even further from the all-time low in June 2017 of 10.5.

So VIX wore a black cloak and with it brought death – of sorts.

Rich Repetto, Sandler O'Neill

Rich Repetto, Sandler O’Neill

To illustrate, Tabb Group, an industry consultancy, said that total revenues brought in by HFTs from equity trading have dropped over 85% from $7.2 billion in 2009 to $1.1 billion in 2016. Tabb said HFT revenue is projected to slide to $900 million in 2017.

Ouch.

“We’ve known for a while that HFT results were exponentially tied to volatility,” began Richard H. Repetto, Principal at Sandler O’Neill + Partners, L.P. “With the extreme low implied and actual volatility, this has presented significant headwinds to HFT and their profitability/spreads.”

And what about changes in market structure?

“I don’t believe market structure changed significantly to cause the decline in HFT,” he continued. “Perhaps the move to passive (index & ETFs) has had some impact on volatility but generally certain HFT benefit from trading these instruments and the underlying securities.”

Sandler O’Neill + Partners’ Repetto continued that if volatility remains low, he thinks there will be continued consolidation. There have been closures, acquisitions and the like already – Virtu acquiring KCG, DRW Holdings agreed more recently to purchase high-frequency trading firm RGM Advisors and DRW also in 2015 agreed to buy the assets of Chopper Trading LLC, joining two of the most prominent Chicago-based computerized trading firms.

“The relatively stronger firms, who also have been negatively impacted by the low vol conditions will seek scale to combat some of these headwinds,” Repetto said. “You had the aforementioned plus Quantlab merged with Teza. However, we also know that European firms like IMC and Optiver appear to be expanding despite the difficult environment.”

Spencer Mindlin, capital markets index analyst at Aite Group, told Traders Magazine he agreed with Repetto and that the HFT business has become one of scale.

“Winners are being decided by whoever is able to best leverage their capital investments and technology across multiple assets, around the globe, and for opportunities in complementary lines of business,” Mindlin said. “When vol comes back, it’s unlikely that many small players will re-enter unless the market structure changes so untapped opportunities emerge.”

Spencer Mindlin, Aite Group

Also, Mindlin added that the technology race is not over and that only the larger (and more profitable HFTs) along with the broker dealers will be able to keep up.

“There has already been a shift to ultra-low latency, which requires significant additional investment beyond the reach of most small to mid-size trading firms. Consolidation is likely to continue,” Mindlin said. “But in the US equities space there aren’t too many more firms ripe for consolidate.”

So Where Do They Go from Here?

However, he added there will always be room for specialization, however, particularly as new assets and markets adopt electronic trading. Those firms able to bring their unique expertise to a particular market in an HFT environment will stick around as long as there are profitable opportunities to trade.

Remember one of the most vocal HFT firms, Red Bank, NJ’s Tradeworx and its then founder Manoj Narang? While Narang has left the powerhouse trading firm that at one time was said to be upwards of 5% of daily exchange trading volume, the firm has shifted some of its energies away from trading and into the data space. It’s affiliate company, Thesys Technologies, provided the Securities and Exchange Commission for its Market Information Data Analytics System (MIDAS) and is now building the new Consolidated Audit Trail, which is used by regulators to better analyze trading.

And it was this migration to the technology delivery business, like the public exchanges have engaged in over the last few years, that could be the next frontier for these firms. As Jamie Selway, Head of Execution Services at ITG told Traders Magazine, these firms have their roots in the technology business so  going from user to provider seems logical and extremely economically viable.

“Another direction is that they (HFTs) might sell technology,” Selway said. “If you’ve invested so much time and energy in this technology infrastructure, you can re-sell it to the market and particularly to broker dealers who have been previously priced out of the technology war between brokers and these firms.”

Jamie Selway, ITG

Jamie Selway, ITG

Another avenue that HFT firms can explore would be related to technology is creation. Selway said that he’d heard of firms creating single dealer platforms, so firms could interact directly with HFTs and cut out the brokers and/or exchanges. He sees this as a global approach to survival as HFTs move away from the US, as Sandler O’Neill + Partners’ Repetto had mentioned.

“HFTs are creating global liquidity and getting in touch with clients directly rather than via brokers or exchanges – think KCG prior to the Virtu acquisition,” Selway said. “The big HFTs are global in scope and multi asset, which could give them access to greater flow.”

But Selway added that neither selling technology or creating new direct platforms would be “lay ups” for HFTs, as price considerations and other factors still apply.

What About Regulation?

Remember back when the Flash Crash happened? Anti HFT rhetoric hit a feverish note and everyone from the buy-side to the sell-side to regulators were arguing to regulate these at-the-time demons of market structure. As time passed and no criminal wrong could be found among the HFTs, regulators could only sound the trumpet of ethics and market fairness publicly. Fast forward seven years now and no one at any regulatory agency is sounding the klaxon.

But what about the next evolution of HFT?

Spencer Mindlin, analyst at Aite Group said that regulation may play an increasing role in how HFT firms operate in the future though, particularly in markets outside of the US.

“As regulators and legislators gain transparency into how their markets operate, they may be compelled to tinker with rules and role of HFT,” he said. “Remember though HFT firms are effectively the modern-day specialists and liquidity providers, no less relevant than ever before. And I might add, the end investor is typically a beneficiary as this sort of automation and disruption brings down costs.”

 

 

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