The high frequency traders who, just a few years ago, threatened to disrupt financial markets with their rapid, algorithmic trading are themselves being disrupted. And that disruption is coming from an unusual source: the markets are too quiet.
At their height, HFTs were widely demonised, most notably in Michael Lewis’s 2014 book Flash Boys which reached the top of the New York Times bestseller lists with allegations that their leading-edge technology was rigging the market against buy-and-hold investors such as pension funds. Congress launched an inquiry and the FBI launched an investigation.
Buoyed by their post-crisis profits, HFTs had embarked on a technological arms race, the firms competing to shave microseconds off the time it took to send trading data around financial markets. There were allegations of criminal abuse, including price manipulation. (Nothing more has been heard of the FBI’s investigation which commenced four years ago, though.)
High frequency trading outfits were able to clean up in the years following the global financial crisis, and during the European sovereign debt crisis, when wild swings in the prices of bonds, equities, currencies, commodities and derivatives provided a fertile stamping ground for their methods, which often rely on computers detecting – and then profiting from – tiny inefficiencies that emerge when prices change.
But in 2017 the situation has changed beyond recognition. Although the ordinary investor may not be fully aware, markets are now at their most tranquil for decades. Volatility in US equity markets, as measured by the Vix index, was at its lowest September level since calculations began in 1970 - that’s in a month that saw the North Korean crisis, the U.S. Federal Reserve saying it would unwind quantitative easing, and more than 300 tweets from Donald Trump (although it has ticked up a little since).
HFT revenues fell 85% between 2009 and 2017 according to Tabb Group
September wasn’t a one-off. One key moment that has led to calmer markets was ECB president Mario Draghi calming Europe’s markets by saying “the ECB is ready to do whatever it takes to preserve the euro”. Those words comforted markets and have played a big part in the crushing 85 per cent fall in HFT firms’ revenues from equity trading - down from $7.2 billion in 2009 to $1.1 billion between in 2016 according to consultants Tabb Group. The consulting firm expects their revenues to slide again to $900 million in 2017.
There may be a lesson here for the current generation of fintech firms. HFTs were the fintech darlings of five years ago. Their technology was indeed impressive – able to receive, assimilate and act on market data across multiple exchanges by placing and cancelling up to 10,000 orders a second – but what wasn’t fully understood was that their profitability was dependent on a particular market dynamic. When that dynamic disappeared, so did their profits.
Ironically, just as their business model has imploded, so they have been cleared of some of the most serious charges against them. Jonathan Brogaard, a professor at the University of Washington and co-author of a paper “High-Frequency Trading and Price Discovery” has knocked holes in the allegation that HFTs make markets more fragile. He and his co-researchers concluded that they make markets more stable and efficient, even when volatility spikes, by quickly bringing prices back into line.
In April 2016 two economists at the UK’s Financial Conduct Authority, Matteo Aquilina and Carla Ysusi, corroborated this view with a paper than seemed to exonerate the flash boys.
The one-time masters of the universe are having to huddle together for warmth
To make matters worse for HFT players, their technology has increasingly been adopted by the larger Wall Street banks – and when everybody’s fast, it’s more difficult to profit from speed alone.
So the once-swaggering masters of their universe are, today, having to huddle together for warmth. In August Chicago-based DRW Holdings acquired Texas-based rival RGM Advisors for as little as $10 million, according to the Wall Street Journal. In July, New York-based Virtu Financial, which floated in 2015, acquired rival high-speed trading firm KCG Holdings for $1.4 billion.
In November 2016, Teza Technologies, one of the pioneers of electronic markets, announced it was quitting HFT altogether, as it was struggling to make any money out of it, and sold its high-speed trading business to Quantlab Financial. “Pretty much the whole industry is up for sale right now” one banker told the Financial Times.
So the next steps for the flash boys look far from certain. They are probably need to capitalise on their technological edge by applying that to new areas – the next frontier of finance – to have long-term future. And the lesson for fintechs? They must avoid becoming so obsessed with their own technical prowess that they lose sight of the bigger picture. Otherwise a central banker might just step in and take their market from under them.
