With shrinking volumes and a steep drop in volatility over the past four years, high-frequency trading in U.S. equities has become a less-profitable business, forcing some firms to exit the market. HFT firms are still dominant buyers and sellers of U.S. equities, but their profits reportedly have slumped from nearly $5 billion four years ago to $1 billion last year. As a result of these trends, firms are diversifying their strategies and adjusting their computerized models to compete.
In a low-volume environment, HFT firms are adjusting their ultralow-latency strategies and shifting to other asset classes, sources say. "The expansion has slowed down a bit," says Brett Diamond, president of Hudson Fiber Network, a data transport firm in Paramus, N.J., that builds low-latency routes for the financial services industry. Diamond suggests that HFT firms are pulling out of markets such as Toronto and Hong Kong that they found weren't as profitable as they thought they would be.
"High-frequency trading absolutely hinges on total market volume," says Christopher Nagy, CEO of KOR Trading, a consulting and advocacy firm in Omaha, Neb., that helps exchanges, brokers and dealers with regulatory and strategic issues. "In effect, what HFT strategies do is provide liquidity to the marketplace, but if there's no one that's interested in purchasing stocks, then the absolute net profits are going to go down, purely as a function of less liquidity in the marketplace."
Overall U.S. equity declined 18.5% last year, averaging about 6.5 billion shares a day compared with 7.8 billion shares in 2011, according to TABB Group. This is far below 2009's average daily volume of 9.77 billion shares. Compounding this even further, off-exchange trading is on the rise. In January, retail flow internalized by wholesale market makers and institutional trades facilitated with broker capital soared to a record 36.75%, according to a report by Rosenblatt Securities.
Thus, industry observers say, HFT firms are operating in a more difficult environment where the cost of remaining competitive and playing the low-latency trading game remains high. "The barriers to entry are colocation fees and carrier connectivity fees," says Diamond, who adds that firms need millions of dollars and also must file with theSecurities and Exchange Commission. "The days of saying I want to open up in 30 markets globally" are gone, says Diamond, noting that costs are more expensive from a carrier perspective.
Just Who Are The HFT Players?
Because there's no official list of firms that fall in the HFT category, no one is sure how big the market is. The major players "can be counted on two hands," Nagy says, and they include DRW Trading Group, GETCO, Hudson River Trading, Quantlab Financial, Tradebot, Tradeworx and Virtu Financial. However, others contend there are hundreds of firms in the space and that it's crowded.
"There are more people in the space, there are fewer opportunities and the opportunities that are found exist for shorter periods of time," says Matthew Samelson, principal at Woodbine Associates. "You've got the challenges of declining volumes, which impact a high-frequency firm's desire to participate in the market," Samelson says. But not all HFT firms are losing profits. In a January article, The New York Times article noted that Tactical Fund, the HFT trading unit of Citadel, posted a 25.7% net return in 2012.
An SEC filing by GETCO, the largest high-frequency trading firm, disclosed an 82% decline in the firm's profits to $24.6 million in the nine months ended Sept. 30, 2012, from $134.8 million a year earlier. GETCO made the filing in connection with its $1.4 billion acquisition of Knight Capital Group, after Knight lost $461 million in August because of a technical glitch. The filing offered a rare glimpse into the finances of the highly secretive proprietary trading firm.
GETCO's total revenue from market making declined 44.2% to $398.5 million for the nine months ended Sept. 30, 2012, from $714.1 million for the nine months ended Sept. 30, 2011. The company attributed the decline to lower trading revenue from market making, which was negatively impacted by lower market volumes and volatilities across asset classes. The increasing internalization of order flow by brokers in U.S. cash equity markets was a factor, GETCO said. In terms of volatility, GETCO noted that over the nine-month period, the average 20-day volatility of the S&P 500 had declined about 28%, while the implied volatility of the CBOE's Volatility Index (VIX) had fallen about 19%.
"It's become very difficult for people to make money in this space because the volatility is low," says Scott Daspin, managing director for the global electronic execution group at ConvergEx, a technology company that provides algorithms. "They need the volatility to play market movements, and if the volume is not there, it's actually hard for them to make money," explains Daspin, whose brokerage firm executes trades for customers who are in the high-frequency trading market, as well as long-only asset managers, hedge funds and brokers.
Fees And Rebates
At the end of the day, fees also play a role in the profits of HFT firms, whose strategies are geared toward earning rebates from the exchanges. "As fees go up, trading goes down. It's more expensive to trade, so you might trade other asset classes and products," Nagy says. The SEC's Section 31 fees are an example, he says.
"With Section 31 fees on the rise and with liquidity access charges on the increase, it's become more expensive to trade equities," he says. Exchanges also offer volume discounts for HFT firms taking liquidity, and they've raised those rates recently. Exchanges have reduced some of their tiers, Nagy says. "If you do more than 10 million shares you qualify for a discount." But some of those discounts have been "eviscerated," he says.
As a result of the low-volume environment, some firms are tweaking their computerized models to go into different asset classes such as futures and FX, sources say. Nagy says he is seeing HFT shifting over to the futures and options markets because the costs are more favorable. In addition, some ultralow-latency firms are said to be revising their strategies for longer holding periods. In its SEC filing, GETCO reports that it spent $37 million on building new trading strategies, including a "mid-frequency" one.