In a quiet room overlooking Madison Avenue, seven miles uptown from the New York Stock Exchange, a dozen people are focused intently on banks of computer screens, where programs trade about a 10th of all the US stocks exchanged in a given day.
For this select group of high-frequency traders, part of the 133-person staff at Virtu Financial, using lightning-fast computer systems to trade US equities is just a start. The company now wants to make high-speed trading the norm in new asset classes such as bonds, currencies and derivatives.
US trading volumes
If Virtu and a handful of its rivals manage to disrupt these new asset classes the way they shook up the stock market, it could spell the end of the long dominance enjoyed by global banks in areas such as bond and foreign exchange trading.
Electronic trading has grown steadily over the past 25 years, but high-frequency trading has boomed since the turn of the century as technology costs and communication networks improve. It has also been associated with hair-raising glitches – most notably the unexplained Flash Crash of 2010 – that some believe has hurt confidence and driven small investors from the US equity market.
The prospect of the speed traders expanding their presence across global markets, linking numerous asset classes ever tighter, poses new challenges to traditional investors, companies – and regulators.
“Although computer-based algorithms have been utilised in US equities markets for quite a while, the expansion into other markets and the proliferation of high-speed algorithmic trading ... could lead to unintended errors cascading through the financial system,” warns the Financial Oversight Stability Council, a top US regulatory oversight committee that includes the chairman of the Federal Reserve and the secretary of the Treasury.
Since the financial crisis, regulators have focused on improving the transparency of opaque markets such as derivatives, which generate enormous profits for global banks. As a consequence, more markets are becoming computerised, opening the door to high-frequency or ultra-fast trading as technological knowhow is applied in new areas.
The potential benefits to investors seem clear: trading will become cheaper and more transparent.
“As high-frequency traders appear in these other asset classes they will start to drive those markets towards a more equity-like structure,” says Eric Noll, executive vice-president of Nasdaq OMX, the transatlantic exchange operator. “Previously they were opaque markets and there was not a lot of visibility to them.”
Regulation: All eyes on Italy’s new rules
Italy is set to become a testing ground for the regulation of high-frequency trading as politicians wrestle with the contentious topic.
Over Christmas, Italy introduced a financial transactions tax that went further than a French equivalent last August. Specific legislation was aimed at high-frequency trading in local equities and derivatives – asset classes that have attracted high-frequency traders because they are liquid and traded on exchanges.
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But the potential downsides are markets plagued by computer errors and outages. Most worrying of all: the risk of a global flash crash across major markets linked by the speed traders.
Some regulators and market analysts also fear that the cost savings to investors from the rise of high-frequency traders have been exaggerated – and that some of their practices ultimately hurt investors.
Eric Hunsader at Nanex, a Chicago-based market data company, says: “When high-frequency trading firms say they have narrowed spreads and are lowering investors’ costs, that only applies to a handful of the most active stocks in the US market. Once you go out of that universe, it’s the wild, wild west. Anything goes.”
An easy definition of high-frequency trading eludes both the industry and its regulators. However, most agree that it involves the automated use of sophisticated computer programmes or algorithms to take advantage of minuscule price discrepancies in fractions of a second.
High-frequency traders have been pushing into other asset classes for years, but entering new markets has taken on new urgency as their profits from equity trading have slumped. While high-frequency trading has grown to account for more than half of all US stock trading, companies have invested millions of dollars into technology that might give them a millisecond advantage, driving up their costs. At the same time, trading conditions have deteriorated. Some say the market is ripe for consolidation.
Getco, a leading high-frequency trading firm, revealed recently that its net income had plunged 82 per cent in the first nine months of last year after opening its books for the first time in its 14-year history. The woes faced by the Chicago-based company were largely the result of a dramatic multiyear decline in its US business.
Even more startling, the company disclosed that overall profitability had peaked in 2008 and had fallen every year since.
The gloom confirmed what many in the industry – where company-specific data are nearly impossible to come by – suspected for some time: that the era of easy money in high-frequency stock trading has long past.
After the expensive “arms race” to buy the technology and maintain the infrastructure necessary to deal stocks at millisecond speeds, high-frequency trading’s role in US stocks, while still dominant, is waning.
“We had a land rush. Anyone can buy a fast computer, get a data feed and hire programmers. Some succeed and those that don’t, wash out,” says James Angel of Georgetown University.
Along the way, total profits for the industry from US equity trades have dropped from an estimated $4bn in 2009 to just $1bn last year, according to research from brokers at Rosenblatt Securities.
The data also show that high-frequency traders made a profit of roughly a 20th of 1cent on each share traded in 2012, down by half from 2009, as retail brokers, banks and buyside investors have quickly moved to adopt the sophisticated computer trading programs, or algos, needed to keep pace.
“We have to make significant investments to support a robust US equities technology infrastructure,” says Doug Cifu, president of Virtu. “As spreads have narrowed considerably in the last five years and competition among electronic market makers has intensified, the relative costs of maintaining and upgrading that infrastructure have been heightened.”
Others say that profits may soon return as market conditions improve.
“The real story here is that volumes and volatility in the equity market are down,” says Rich Gorelick, chief executive of RGM, a Texas-based proprietary trading firm.
Many firms say that a multiyear collapse in equity trading levels, which have declined as investors pulled funds out of the stock market after the financial crisis, is squeezing opportunities for rapid-fire trades.
Large swings in prices, another critical condition for high-frequency traders to prosper, have also lessened. They thrive in turbulent markets where there are more chances to take advantage of tiny differences in prices across trading venues. The Vix index, which measures implied volatility on the S&P 500, currently sits at multiyear lows.
Justin Schack, managing director at Rosenblatt Securities, says this helps explain why the sector’s profits peaked in 2009 even as the stock market was plummeting.
“We are going through a shakeout,” says Mr Schack. “When the tide was high it was high for all boats, it worked for people who rushed in. But as this profitability has dried up, I think you’re seeing a shakeout not only of the small firms but even some of the very highly touted new entrants.”
Among those, Eladian Partners, a high-frequency trading firm started by former Citigroup executives with backing from private equity companies, shut its business down in October, citing market conditions.
“It’s a typical Wall Street tale where people see a pot of money and they all run to it,” says Seth Merrin, chief executive of Liquidnet, an alternative trading venue built to protect institutional investors from having their orders front-run by speedier traders.
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High-frequency trading in assets such as futures and fixed income has picked up in the past four years just as its presence in US equities has waned. The gains are most visible in foreign exchange, where the global market share of high-frequency trading has soared to 40 per cent up from just a quarter in three years, according to Aite Group, the financial services consultancy.
Jamie Selway, head of liquidity management at brokerage ITG, says: “The electronification of different asset classes has already begun happening. It’s going to be pervasive and it’s going to change the landscape for all market participants.”
But just like stocks, where regulators at the Securities and Exchange Commission have worried for years that speedy traders are taking advantage of slower investors, some concerned foreign-exchange market participants are moving to curtail the influence of high-frequency traders.
Gil Mandelzis, chief executive officer at EBS, the currency trading platform owned by brokerage firm ICAP, distinguishes between what he calls “ultra-HFT” and other types of computer-driven algo trading.
“People with speed as their sole strategy for trading do not add value to the overall market of our clients,” he says.
Last year EBS introduced measures designed to curb the predatory practices of some high-frequency traders. Such efforts included the widening of the spread of pricing on some of its currency pairs, so the fifth decimal point in a quote had to be a “5” or “0”. EBS also raised the ratio of quotes traders were allowed to send before they were required to buy, measures that reduced “flash orders”.
“We want to make sure that the environment we are in charge of at EBS is conducive to trading and not just speed. We don’t get up in the morning just wanting to create the fastest racetrack. That’s not my job description.”
Getco says that it believes it will see further gains in fixed-income trading through legislation such as the Volcker rule. It also believes high frequency will move into formerly over-the-counter traded swaps.
The revelations came as Getco seeks shareholder approval for its $1.8bn acquisition of Knight Capital, a US trading firm that was severely weakened by a $460m trading loss in August resulting from a glitch, which caused its systems to erroneously acquire $7bn of equity positions in just 45 minutes.
While the glitch, labelled the “Knightmare”, did little harm to most investors, it highlighted the speed with which a computer error could ravage a company and shake confidence in the system.
Back at Virtu, one of the main defences against high-speed computer glitches, sits at the heart of its trading floor: a lone systems manager, who stares into nine screens monitoring the status of every connection and trading venue that the company’s systems are hooked into.
If something goes wrong, he immediately turns to a decidedly retro piece of technology: the telephone.
