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High-Frequency Trading a Game-Changer for the Natural Gas Market

Fierce HFT competition has narrowed spreads to virtually nothing in equities, so traders are looking for markets with fatter margins, which makes the commodities markets attractive.

Earlier this week, our Ivy Schmerken pointed to the closure of Eladian Partners as an ominous sign for high-frequency trading, whose profits are being crimped by declining equity volumes.

The news about Eladian came on the heels of numerous reports of both large and small HFT shops either shutting down altogether, or trimming headcount with the industry's profits down 35 percent from a year ago. Since the spreads in equities are so narrow, HFT shops need to execute tons of volume to reap gains from tiny price moves.

But even when equity volume makes its inevitable comeback, it's reasonable to question whether HFT stock trading has already seen its best days. In Europe, 11 countries vowed to press ahead with a Tobin tax that most experts say will crimp their profits even further. And while such rules are unlikely here in the U.S., with competition so fierce and equities spreads so narrow, I wonder if HFTs will ever see the type of returns they saw in 2009 off stock trading alone, when they raked in a record $4.9 billion in revenue, according to data compiled by Rosenblatt Securities.

With profits harder to come by – at least momentarily – it won't be surprising to see HFTs increasingly looking to deploy their strategies beyond equities. University of Houston professor Craig Pirrong says they're already beginning to stir the pot in the natural-gas futures markets.

In a piece for CME Group , Pirrong says fierce HFT competition has narrowed spreads to virtually nothing in equities, so traders are looking for markets with fatter margins, which makes the commodities markets attractive. As a result, Pirrong predicts that spreads in natural gas, and commodities in general, will narrow as HFTs increasingly pour their technology and capital into those markets.

But this scenario is already beginning to spook veteran traders, particularly in natural gas, Pirrong says.

From Pirrong's piece:

New entrants lead to reduced prices and drive returns to just cover the cost of capital. That's exactly why some veteran traders are "spooked." They can't compete against HFT. Their "oxen are being gored," just as traditional market makers' oxen were gored in equities.

As was the case in equities, the entry of HFTs into this space could make these markets reliant on computerized trading systems and potentially reduce liquidity when it's most needed, according to Pirrong. But he also notes that this isn't necessarily unique to electronic markets or HFT.

It is a feature of market-making in general. Market-makers reduce their supply of liquidity when they suspect order flow is toxic, or when risk is rising substantially.

It was so when market makers wore handle bar mustaches and button up shoes and stood in trading pits. It will be so when market-makers are (invisibly operating their models inside) co-located servers. It's inherent in the nature of market-making, not in the technology.

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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