Investments, Trading

High-Frequency Trading: Why HFT Will Likely Stay in the Long Run

August 18, 2017

“Numerous analysts suggest that high-frequency trading companies’ profits are shrinking and in future such businesses are doomed.”

While the first part is true, the latter is a pure non-sense.

The financial sector loves to get into periodical obsessions. One of its previous manias – the credit derivatives and the way they were used, had led us to the biggest financial crisis since the Great Depression. After the short-term decline, does it now look like banks have quit or are at least more careful when trading derivative instruments? The answer is – no. (As of now, the OTC derivative market is estimated at more than $490 trillion.)

Replace “credit derivatives” with “high frequency trading” and the scenario won’t change much. Analysts have pointed out that the profits of high frequency trading companies are on a stable decline. That is a fact. But stating that these businesses will be wiped out due to that is equal to saying that investment banks will fire their quant departments just because structured products are not as popular as they were before the crisis.

High Frequency Trading is the market reality – the technology that is behind more than 50% of all trades.

Reasons for the Declining Profits of High Frequency Trading Companies

You Don’t Have the Crystal Ball

Most of the high frequency trading companies are privately-owned. Making a judgement on the profits of the whole industry based solely on a few publicly-traded companies can lead to biased conclusions. Since 2015, Virtu and Flow Traders reported declining earnings. That led some analysts to premature conclusions that these two-years results are decisive for their future. Question: did the analysts take into considerations, the trends in the VIX (the index measuring implied volatility levels)?

high-frequency trading VIX Index

High Frequency Trading Flourishes in Periods of High Volatility

For the last two years, the implied volatility has hit the lowest levels since the 1970s. This appears as a significant barrier for new HFT shops that are trying to enter the business. It is reasonable to expect that when the VIX rises, companies like Virtu will get back on the winning track. In fact, the company has never been on a losing path, as its EBITDA margin for the Q2, 2017 is 53.1%. The company said that they have earned money every single day of the last year. Nevertheless, some analysts came out with titles such as “Don’t Worry, Be Happy – High Frequency Trading Is Over, Dead, It’s Done”. Too early for such conclusions!

HFT is a much Competitive Industry

As the competition in the industry has risen to unseen levels, more ineffective high-frequency trading companies started to leave the market due to their declining market share. The essence of this industry can be summarized in one word – speed. And gaining speed requires large investments in infrastructure, data feeds, collocation services and etc. This is the main reason why this industry has way higher maintenance costs in comparison with others. Taking into account the fact that many of the major exchanges increased their collocation service fees for high-frequency trading companies, it seems reasonable to assume that new companies are heading for an early exit. While some companies’ profits tumble, others, such as XTX Markets’ are booming significantly, so the industry is not going down – it is in some kind of equilibrium.

Pressure from the Regulators

Nowadays, for HFTs it is way harder to churn the excessive profits that they were used to few years ago. The industry is subjected to constant pressure from the regulatory authorities, despite the fact that there are no established laws mandating the regulation and control of the high-frequency trading business. Nevertheless, that fact also accounts for more careful trading activity by the high-speed companies. The uncertainty in the existing regulatory framework in the recent years has led to numerous cases of traders or companies being sued because of some kind of “market manipulation”. However, in reality, regulators do not have any proposed and established definition on what accounts for such violation (for example – how many order cancellations will account for “market manipulation”).

The Role of Exchanges

IEX, the newly licensed exchange, employs a speed barrier of 350 microseconds in an attempt to diminish the speed advantage of HFTs, who already accounts for 2.1% market share. The growing interest in this venue has made other exchanges rethink their fees. All of this have resulted into growing costs for the high-frequency trading companies.  

5 Reasons Why the High Frequency Trading industry will not Disappear?

Reason #1: High Frequency Trading is the new Market Environment

HFT is what dominates the markets right now. It has turned itself in the natural environment. 1 in 2 trades are processed by HFT. Here we are not talking whether it is good or bad for the healthy functionality of the markets, the fact is that it is the reality – it won’t disappear. Moreover, HFTs volume are on the rise again.

high frequency trading volumes

Reason #2: The cat-and-mouse game

The financial industry is always trying to be one-step ahead of the regulators. That is understandable because of the time needed for a prudent framework to be proposed and established. That is why various financial niches such as high frequency trading have enough time to plan their business processes and to adopt a smooth period of adaptation to the new rules of the game. Whatever challenges are imposed by the authorities or regulators, be it taxation, speed limits and etc., the HFT industry will always try to pre-empt and find the solutions.

Reason #3: Constant developments in High Frequency Trading

With the rapid development of technology and the rise of new global tendencies in IT, high frequency traders are reshaping their trading strategies in a way, unseen before. For example – the news-driven trading strategies are gaining increased popularity in the recent years. Sentiment trading, pattern recognition and other similar approaches are already employed by different companies. Speed will no more be the main advantage for high frequency traders as they are turning their heads to AI. The clash of algorithms is on the horizon. Speed will only be an additional advantage – not the decisive factor.

Reason #4: High Frequency Trading Focusing on Emerging Markets

Responsible for more than 50% of the equity trading volume in the USA and Europe, HFTs are now turning their focus to emerging markets. The fact that most of the BRICS do not have stamp taxes and are open to attracting foreign businesses makes them preferred markets for HFTs. This provides them with new, big and hungry for technology markets which will only please HFTs.

Reason #5: The Industries’ Interconnectedness

The high-frequency trading business should not be considered as a self-serving one. There are many reasons why its downfall may lead to the so called chain-effect. For example – HFT companies are exchanges’ biggest customers. Losing them means bigger fees for other market participants. One has to be conscious about the significant investments that were deployed in building the infrastructure and high-speed internet connection. And what about the companies that focused on hardware development and specifically – microchips for faster trade execution? These niches are all serving their biggest clients – the high-frequency trading companies.

In conclusion – every industry is a cyclical one. And it is absolutely normal that after the significant boom in HFTs business in the aftermath of the Global Financial Crisis, we are on the verge of its significant overhaul. The ambitions and the path of the high frequency trading industry are clear:

“Electronic trading, including HFT, will eventually replace traditional trading models. That’s going to happen everywhere in the world, even in the most illiquid [markets].

Larry Tabb, CEO, TABB Group

about author

Viktor has an MA in Financial Markets. He is an experienced "R" developer, specializing in performing analysis and conducting researches for various start-ups in the financial sector. He has solid research experience and has developed a course on the topic of high-frequency trading: https://www.udemy.com/high-frequency-trading-dark-pools/?couponCode=HFTCOURSE.