By Irene Aldridge
Recent proclamations (see Forbes, ZeroHedge and others) that high-frequency trading in equities has become too competitive and unprofitable for many firms has prompted exits and fire sales of assets. The recent mergers and consolidations in the HFT industry are indeed real. And as described in our new book, “Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes” (Wiley, 2017), the technologies required to successfully trade at high frequencies have indeed become increasingly sophisticated. However, the reports of death of HFT may be highly premature.
Our firm, AbleMarkets, tracks the participation of a specific group of high-frequency trading strategies as a percent of volume traded across all electronically-traded financial instruments, including equities, commodity futures, foreign exchange and U.S. government bonds. The HFT strategies that we track include those acting on news releases, statistically-unjustified price discrepancies (known as statistical arbitrage) and other time-sensitive information. These HFTs tend to prefer market orders over limit orders to capture the current state of the market as fast as they can, earning them a nickname of “aggressive” HFT. These strategies do not include HFTs that rely on market-making to make money, known as passive HFT. As our book, “Real-Time Risk” describes, unlike passive HFT, aggressive HFTs cause spikes in volatility by their very basic actions resulting in very real pockets of extreme market risks.
Figure 1 shows AbleMarkets estimates of aggressive HFT for the past five years, presented as an average of aggressive HFT activity across the entire universe of stocks comprising Russell 3000 index (which are the 3000 most commonly traded U.S. stocks). As Figure 1 shows, aggressive HFT participation as a percentage of volume traded across the Russell 3000 index has steadily increased over the past 5 1/2 years since AbleMarkets has begun tracking the HFT behavior.
So what prompted commentators to declare that high-frequency trading was dead? A recent wave of acquisitions in the HFT space would normally be a sign of industry maturity. Afterall, companies choose to sell out when the growth in profits slows down and someone else can take advantage of their corporate know-how. Recent reports have said that HFT earnings are slowing down and the industry overall is not as lucrative as it used to be. The reports are based on subjective quotes and opinions of industry commentators without sufficient depth to analyze the markets.
At AbleMarkets, we politely disagree with these opinions based on the analysis of data. Our analyses show that aggressive HFT remains highly profitable. Indeed, the accumulation of wealth by the founders of HFT firms is so rapid that the incentives of maintaining a long-term HFT operation fade when you consider the requirements of staying competitive. First, the sophistication required to design and operate high-frequency trading systems has been increasing continuously and dramatically over the past two decades. What was once considered to be a trivial problem is now a complex matrix of decisions in infrastructure, models and trading venues. Staying on top of innovation is a demanding process, prompting many to exit after a sufficient nest egg has been built up. Second, HFT is and has always been a very stressful business, where a minor computer glitch can wipe out millions of dollars in a matter of seconds and minutes. To wit, consider the fiasco of the Knight Capital Group (KCG) in 2012, where KCG lost $440 million in a matter of 45 minutes and from which the firm has never recovered. Choosing a low-stress low-demand lifestyle may simply be the best choice for many early entrants in the HFT field. Facts show, however, that, despite the reports, aggressive HFT is growing in the U.S. equity markets.
Irene Aldridge is Managing Director, Head of Research at AbleMarkets, a Big Data for Capital Markets company, specializing in real-time and near-real time Software-as-a-Service improving execution, portfolio allocation and risk management. She is a co-author of #1 New Release and Number 1 International Bestseller in Financial Risk Management category “Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes” (Wiley, 2017), and an author of “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems” (Wiley, 2nd edition, 2013). She can be seen at the upcoming 5th annual Big Data Finance Conference at NYU Center for Data Science on May 19, 2017.