A Blog by Jonathan Low


Mar 23, 2017

The Reason Algorithmic, High Frequency Traders Are Falling On Hard Times

As with so many financial innovations, being first does not establish sustainable competitive advantage.

Just as every business is now a tech business, so every financial institution is now - at least in part - an algorithmic trader. JL

Alexander Osipovich reports in the Wall Street Journal:

The industry is having trouble making money. HFT firms use computers to buy and sell financial assets in fractions of a second. The once-lucrative business is now fighting unfavorable market conditions, brutal competition and rising costs. Revenues at HFT firms from U.S. equities trading were $1.1 billion last year, down from $7.2 billion in 2009. “In volatile trading environments, it was easier to find trading opportunities.”
The flash boys aren’t as flashy as they used to be.
High-speed trading gained notoriety after Michael Lewis’s 2014 book “Flash Boys.” These days, the industry is struggling with another problem: It is having trouble making money.
HFT firms use computers to buy and sell stocks, bonds or other financial assets in fractions of a second. The once-lucrative business is now fighting unfavorable market conditions, brutal competition and rising costs.
Revenues at HFT firms from U.S. equities trading were an estimated $1.1 billion last year, down from $7.2 billion in 2009, according to research firm Tabb Group.
That is the backdrop behind last week’s news that Virtu Financial Inc. had made a bid to buy rival KCG Holdings Inc., a proposed deal that would unite two of the biggest U.S. electronic trading firms. Virtu’s stock has shed about a fourth of its value since the company went public in 2015, while KCG’s key market-making business has lost money for the last two quarters.
Other industry heavyweights are exiting altogether. Thomas Peterffy, chairman and chief executive of Interactive Brokers Group Inc., said this month he would end his firm’s options market-making activities, a business he helped pioneer in the 1980s. Misha Malyshev, who once led global HFT for hedge fund giant Citadel LLC and left to start Teza Technologies, said in November that Teza would exit its proprietary trading business.
Market making involves buying and selling in large volumes and collecting small profits from the difference between the buying and selling price. It is a core strategy for HFT, which accounts for just over half of average daily volume in U.S. stocks trading, according to Tabb Group. Other strategies include exploiting fleeting disconnects between related markets, such as exchange-traded funds and futures contracts that both track the S&P 500.
Such strategies are more successful when markets are volatile, because big price swings offer traders more opportunities to capture profits. But volatility has come down drastically since the years just after the global financial crisis. The CBOE Volatility Index, or VIX, a measure of U.S. stock market volatility, has averaged just 11.6 so far this year, down from 24.2 in 2011, according to the WSJ Market Data Group.
“In very volatile trading environments like in 2009 and 2010, it was just easier to find trading opportunities,” said Michael Beller, chief executive of Tradeworx, an HFT and financial technology firm in New Jersey. “Now everyone has to work harder to find the trades.”
HFT became a hot-button political issue after “Flash Boys” alleged that firms were taking advantage of investors. Advocates reject such allegations and say HFT has actually reduced costs for the average investor.
It is an expensive arms race. When many high-speed traders got their start in the 2000s, the leading technology for transmitting data was fiber-optic cable.
But starting in 2010, the speediest firms began to use microwave networks, shaving milliseconds off the time it takes to transmit information on routes such as the Chicago-New York corridor. Upgrading to microwave networks—and later millimeter-wave and laser technology—added to the costs, traders say. All this hurt HFT firms’ bottom lines just as slumping volatility was eroding their top-line revenues.
“The cost of keeping up with the Joneses is quite high,” said Jamie Selway, a managing director at New York-based brokerage ITG.
HFT firms also grumble about mounting costs for the market data they buy from operators like the New York Stock Exchange and Nasdaq Inc., as well as for co-location, the practice of putting a computer server directly in the exchange’s data center to cut down the time it takes to execute trades.
Chicago-based Wolverine Trading LLC told the Securities and Exchange Commission in December that its total costs related to NYSE equities market data had more than tripled from 2008 to 2016. “This is a monopoly,” Wolverine said in a letter to the SEC.
NYSE rejected the accusation, telling the SEC in January that firms like Wolverine had “chosen to build business models based on speed” and could choose not to buy NYSE’s highest-speed data services. Intercontinental Exchange Inc., the owner of NYSE, and Nasdaq say their fees are reasonable.
Amid the crunch, the industry has consolidated and the most successful players have diversified across multiple asset classes, which makes it easier to weather stretches of low volatility in one market. Virtu, for instance, made under a third of its trading profits from Americas equities last year, with the rest coming from European and Asian equities, currencies, commodities and other markets.
Some industry veterans also say the profits have suffered because HFT firms can no longer exploit structural flaws.
“The loopholes got cleaned up,” said Haim Bodek, a former managing director and head of electronic volatility trading at UBS AG.
One such loophole, according to Mr. Bodek, involved dark pools run by some large banks and brokerages. The off-exchange trading venues need access to the latest price data from exchanges to ensure they are executing trades for customers at competitive prices. In years past, some used a relatively slow public data feed. That makes it possible for a high-speed trader to see a stock price moving a fraction of a second before the dark pool does, and quickly trade against the outdated price available in the dark pool.
Mr. Bodek said that strategy had largely been eliminated as dark pool operators switched to faster feeds. Other traders say strategies based on structural flaws were never a significant share of HFT revenues.
But Mr. Bodek, who now leads a market-structure consultancy, sees it as one more blow to the beleaguered industry. “It’s like a perfect storm,“ he said. ”The cheats are going away, the volatility is going down and the costs are going up.”


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