High-frequency trading: Business gets tough for Wall Street gunslingers

The prospects of a return to the good old days continue to fade for Wall Street’s fastest gunslingers. These are the trading firms that dart in and out of shares at rapid-fire speeds using sophisticated technology to make fractions of a penny.

Nearly five years have passed since cumulative profits peaked for high-frequency trading (HFT) companies that buy and sell stocks at millisecond speeds on the US market, according to industry estimates.

As competition has stiffened between those that survived the downturn, the conditions that allow companies to thrive have deteriorated since HFT’s most profitable days.
Optimism that daily US trading volumes will return to pre-crisis levels has faded, as have the frantic bursts in volatility that send shares in diverging directions, creating the opportunities that lured so many entrants into HFT.
“It’s been a tough market. High-frequency trading companies are struggling [to cope with] a lack of volatility and trading volume, competition and a cost structure that continues to go up,” says Larry Tabb, founder of the consultancy Tabb Group.

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“The ability to generate returns, especially in the US equity market, is pretty challenged. They are moving overseas and into other asset classes,” he adds.

The maturing of the US equity market as far as HFT was concerned was confirmed this year as Getco, one of the largest and most prominent companies to emerge from the HFT boom in the last decade, revealed a multiyear slowdown in its proprietary trading business.

The company, known just a few years ago for its relentless investment in the technology and knowhow to beat other speed traders, decided it would move in a different direction.

It acquired in December Knight Capital, known for its client-facing trading business, for $1.8bn.

“Getco and firms like Getco that grew out of the electronification of the markets in the first decade of the century also grew with an explosion of volume and volatility,” says Daniel Coleman, who led Getco and is chief executive of KCG, the combined company that formed following the acquisition of Knight.
Mr Coleman says the company’s backers realised that opportunities to prosper in HFT relied on a competitive technological position – which was expensive to maintain – and favourable market conditions.
KCG will instead concentrate on applying the once-secretive trading techniques and technologies it used for Getco’s own accounts to help clients execute trades.
Jamie Selway, head of liquidity management at brokerage ITG, says: “Firms like Getco were very much one-trick ponies with highly visible strategies that relied on incredibly high volumes to bring in incredibly low return. Their day has come and gone.”
While KCG insists it is not turning its back on proprietary trading, the industry appears to be heading toward consolidation as companies find the climate difficult to navigate.
Allston Trading and RGM Advisors, two leading high-frequency trading companies, were reported to be discussing a tie-up in June.
Those that intend to battle through the difficult conditions in the US equity market must contend with the constant cost of upgrading expensive infrastructure and freshening up their trading strategies to stay ahead of the pack. The HFT companies must fight to keep top engineers and programmers from being poached by rivals and the broader trading industry, which has spent heavily to become more sophisticated.
“The techniques that HFT shops are using are not exclusive to them any more,” says Joshua Walsky, chief technology officer at Broadway Technology, which provides software to trading companies. “If a traditional bank is using those techniques, they are essentially competing.”
He adds that companies must factor in the cost of trading errors that can amass rapidly because of a glitch or problem with a computer system, such as that which caused Knight to lose $460m in a matter of minutes in August 2012 and led to its takeover by Getco.

Goldman Sachs inadvertently accumulated hundreds of thousands of options contracts last month.

Mr Walsky says: “The industry is seeing that there is a real cost to [making] errors, which we call system risk.”
Meanwhile, companies such as Virtu Financial, which have spent heavily to push into new markets and asset classes, have emerged as the leaders of the industry.
The consolidation and geographic expansion is not expected to have any significant impact on the highly fragmented nature of the US equity market, which has grown to 13 exchanges and dozens of alternative trading platforms, to accommodate speed traders.
Mr Tabb says: “You are seeing a number of players consolidate, but the venues remain separate.
“What we’ve learned is that when you consolidate markets, you hurt liquidity. I’m not sure we’re going to see a whole lot of consolidation of trading venues and liquidity pools. You may just see fewer people on them.”