Much has been made recently in the press and in the corridors of Wall Street firms of the notion of high-frequency trading (HFT). Increasingly, the water cooler chat has evolved into formal regulatory reviews in Washington and Brussels.
While much of the chatter is fairly uninformed, the current spotlight on HFT is a recognition of the advances in electronic trading and the evolution in equities market structure that have occurred over the last several years due to significant developments in both technology and regulation.
HFT in equities is a method to implement a certain type of strategy. It is a means, not an end. Although HFT strategies are complicated, they typically boil down to leveraging ultra-low latency trading technology to detect execution patterns and momentary intra-day pricing anomalies. HFT is highly dependent on these strategies actually working.
If these opportunities disappeared, so would HFT. As a means, HFT harnesses inherent factors in the U.S. and European equities market structure (i.e. rebates) while building on successive market innovations (e.g. high performance connectivity, low latency market data and co-location) in order to flourish.
At the moment, let us focus on the U.S. Many types of firms engage in HFT, but automated market makers, hedge funds and proprietary traders are the most common. A reliable estimate of the pervasiveness of HFT in the U.S. is one based on an assessment of the underlying strategies themselves, not necessarily the types of firms.
However, lacking precise data, our proxy for strategy is strong sensitivity to latency in the trading process. Today, our research suggests that latency-sensitive trading is highly pervasive and as a result we estimate that 42% of U.S. equities volume (measured in shares) is the result of HFT and will grow to 54% of volume by 2010.
A higher penetration of HFT will be multi-faceted and driven by an increase in the number of proprietary trading firms, an expansion of quantitative hedge fund strategies, and increasingly technology-driven automated market making. In addition, the convergence of fundamental and quantitative strategies by investment firms will mean the coupling of execution and investment strategies, leading to greater HFT adoption among even more traditionally conservative organizations. In other words, a rising HFT tide will lift all boats.
In evaluating the impact of HFT in the U.S. we find both pros and cons. Pros come in the form of increased liquidity provisioning, narrowed spreads among certain stocks, faster and more reliable execution speeds, and enhanced volumes to U.S. exchanges, suggesting a healthy marketplace for price formation.
Cons come in the form of increased intra-day volatility in some stocks, adverse selection for some market participants, and higher implementation shortfall costs (though separating the effect of higher IS costs attributed to the financial crisis as opposed to HFT adoption is challenging). In this grand game, low-tech institutional trading firms are complaining about the unfair playing field afforded to these high-frequency, high-technology players. But the reality of the new, evolved electronic trading environment is that the new trading rules are now based on technology more than ever.
Back to the rest of the world. The adoption of HFT in Europe is less as a percentage of order flow than the U.S., but is growing. At the same time, HFT will most certainly expand in Asia over the next several years, with selected Asian marketplaces like Tokyo, Singapore, Hong Kong and Australia with the most potential for evolutionary changes at present. With the major upgrade of the Tokyo Stock Exchange’s new Arrowhead system, the number of HFT firms trading Japanese equities will grow significantly. We also expect that Arrowhead will spur other innovations and compel more U.S. and European firms to locate trading applications closer to the exchange matching engines in Tokyo.
Similarly, these firms may also move to be physically closer to other Asian exchange matching engines. However, as a result of more heavy-handed regulation, culture and vested interests, the equities market structure in Asian markets should be slower to evolve than Europe post-MiFID introduction. Hence, we expect the HFT growth trajectory will not accelerate to the levels seen in U.S. and Western Europe anytime soon.
About the Authors
David Easthope is a senior analyst in Celent’s securities and investments practice and is based in the firm’s San Francisco office. He is a Chartered Financial Analyst (CFA) and member of the San Francisco Security Analysts Society. Easthope’s expertise lies in securities trading and post-trade systems, including exchange platforms, electronic communication networks (ECNs), alternative trading systems (ATSs) and dark liquidity pools. He is also an expert in exchange and broker-dealer strategic initiatives, including the introduction of new multilateral trading facilities (MTFs), block and anonymous order types, algorithmic trading, and IT procurement/partnerships.
Chermaine Lee is an analyst in Celent’s Securities and Investments group and is based in the New York office. Her current research includes direct market access and electronic bond trading in the U.S.