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Adam Sussman, Director of Research, TABB Group
Adam Sussman, Director of Research, TABB Group
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TABB Group Pulls Back the High-Frequency Trading Curtain

TABB Group outlines a few principles to which it adheres when discussing the controversial subject of high-frequency trading.

For the most part, high-frequency hedge funds engage in short-term trading opportunities rather than bona fide liquidity-based strategies. While the umbrella term statistical arbitrage is frequently applied to strategies with extremely high volumes, there is plenty of ambiguity in this term. It is also true that the majority of funds engaged in statistical arbitrage are not high-frequency by today's standards. However, over the past 18 months the line between high-turnover strategies and HFT has blurred as hedge funds shorten their time horizons in the face of unexpected market events.

As a result, transaction costs are becoming even more paramount to this sophisticated community. The rationale is that as time horizons shorten, capacity constraints increase and transaction costs become a bigger piece of the pie. High-frequency hedge funds may be layering these liquidity strategies on top of their other strategies so that transaction costs are additive rather than negative.

How Big Is It?

The only art more forgivable than economic forecasting is estimating the market size of an industry that will never reveal its true number. Nonetheless, TABB Group estimates that high-frequency trading accounts for 61 percent of U.S. equity share volume (remember to double-count average daily shares!) and generates $8 billion per year in trading profits.

The methodology begins with an analysis of institutional equity trading volume that we have been collecting since 2006 from 115 U.S.-based equity head traders, including equity assets under management, average daily volume and the percentage of shares executed in blocks. We extrapolate that data to the broader institutional landscape. Retail trade numbers and data from the government are used to determine retail flow. Data from NYSE and Nasdaq and historical market making volumes enhances our picture of current electronic market-making volumes. Last but not least, we discussed our methodology and trading profit calculations (.0024/share) with several HFT hedge funds, independent high-frequency traders and registered market makers.

Is It Good for the Market?

This is the wrong question. The right questions are whether the current market structure can be improved, and what the role of HFT should be in any revised market structure. But that is a scary question because outside of consulting (ahem), IT and perhaps the end investors, there is little for the industry to gain out of major changes to market structure.

The market structure changes and technological advances over the last decade that have made it possible for virtual market makers to supplant the traditional players are viewed as primarily positive for the market. Very few participants or observers suggest that we should roll back the clock on decimalization and exchange competition. Participants feel today's market structure is orderly despite its complexity, and that it does a very good job of encouraging price discovery (see chart).

How Well Does Market Structure Support the Following Characteristics?

High-frequency equity trading is the lovechild between 12 years of SEC rulemaking and advances in trading technology. The combination of these two trends has been necessary and sufficient to unleash an array of new trading strategies. The continued success of these strategies has exchanges and ECNs, brokers and clearinghouses, and market data providers and technology vendors launching new business models and offerings to support high-frequency traders or to help others adapt to this new environment. Imagining a U.S. equity market structure without high-frequency traders is like trying to remove the c from E=mc2.

Adam Sussman is director of research for TABB Group. Previously he served as a senior product manager at Ameritrade, where he was responsible for order management systems, routing and next-generation trading tools focused on the equities and options markets.

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