C&B Notes

High-Frequency Trading In Decline?

High-frequency trading (HFT) has received a lot of attention lately as “legalized front running.”  Businessweek suggests, however, that HFT overall is in decline as trading speed becomes more of an expensive commodity than a sustainable competitive advantage.  Capitalism is relentless at destroying excess profits.

For the first time since its inception, high-frequency trading, the bogey machine of the markets, is in retreat. According to estimates from Rosenblatt Securities, as much as two-thirds of all stock trades in the U.S. from 2008 to 2011 were executed by high-frequency firms; today it’s about half.  In 2009, high-frequency traders moved about 3.25 billion shares a day.  In 2012, it was 1.6 billion a day. Speed traders aren’t just trading fewer shares, they’re making less money on each trade.  Average profits have fallen from about a tenth of a penny per share to a twentieth of a penny.  According to Rosenblatt, in 2009 the entire HFT industry made around $5 billion trading stocks.  Last year it made closer to $1 billion.  By comparison, JPMorgan Chase (JPM) earned more than six times that in the first quarter of this year.  The “profits have collapsed,” says Mark Gorton, the founder of Tower Research Capital, one of the largest and fastest high-frequency trading firms.  “The easy money’s gone.  We’re doing more things better than ever before and making less money doing it.”

“The margins on trades have gotten to the point where it’s not even paying the bills for a lot of firms,” says Raj Fernando, chief executive officer and founder of Chopper Trading, a large firm in Chicago that uses high-frequency strategies.  “No one’s laughing while running to the bank now, that’s for sure.”  A number of high-frequency shops have shut down in the past year.  According to Fernando, many asked Chopper to buy them before going out of business.  He declined in every instance.

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Getco’s woes say a lot about another wound to high-frequency trading: Speed doesn’t pay like it used to.  Firms have spent millions to maintain millisecond advantages by constantly updating their computers and paying steep fees to have their servers placed next to those of the exchanges in big data centers.  Once exchanges saw how valuable those thousandths of a second were, they raised fees to locate next to them.  They’ve also hiked the prices of their data feeds.  As firms spend millions trying to shave milliseconds off execution times, the market has sped up but the racers have stayed even.

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As profits have shrunk, more HFT firms are resorting to something called momentum trading.  Using methods similar to what Swanson helped pioneer 25 years ago, momentum traders sense the way the market is going and bet big.  It can be lucrative, and it comes with enormous risks.  Other HFTs are using sophisticated programs to analyze news wires and headlines to get their returns.  A few are even scanning Twitter feeds, as evidenced by the sudden selloff that followed the Associated Press’s hacked Twitter account reporting explosions at the White House on April 23.  In many ways, it was the best they could do.