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The Trading Mesh

How The Speed Traders are Adapting to Changing Markets

Wed, 28 Nov 2012 09:12:00 GMT           

In this interview for HFT Review, we talk to Edgar Perez, author of The Speed Traders.

 

As one of the HFT industry's most well-connected individuals, who is a frequent speaker at industry conferences and who is regularly invited to discuss the topic on media channels around the world, Edgar is well-placed to deliver his views on the changing nature of high frequency trading in todays markets.

 

HFT Review: Edgar, welcome to HFT Review. To start with, what is your own definition of high frequency trading? 

 

Edgar Perez: Personally, the definition of high-frequency trading is not set in stone. What I can give you is a definition that is practical at this moment: high-frequency trading is really a number of techniques to facilitate speed trading. This is of course an evolving definition. Whatever is HFT today was probably ultra HFT in the past and will probably be low HFT in the future. What we can say at this moment about HFT is the big impact speed has on it.

 

Speed plays an important role and it is a big component of the definition of HFT. By that we mean speeds in the millisecond or microsecond range. In addition to that, in order to minimize the latency of the trading systems, co-location is an inherent part of the definition. As speed traders try to reduce any latency, they will want to trade from computers hosted on the exchanges themselves.

 

As a trader, you don't want your computers to be placed somewhere far away from the exchanges. Therefore, you rent space from the exchange; that will be the second component.

 

As third component of the definition, you are talking at people who trade in and out throughout the day. As a high frequency trader, you are not interested in holding instruments for any longer that it is required by the strategy, and almost never overnight, as that would expose to additional risks. It's been said that high frequency traders are in the moving business and not in the storage business. That means that they will buy share and then sell them at a profit almost immediately. It that is not the case in the transaction itself, it will become profitable thanks to the rebate that exchanges pay traders either for providing or taking liquidity.

 

The fourth component I can think of is that we are looking at trading instruments that are very liquid; if you look at the markets, the most liquid instrument in recent months was probably Citigroup: it was liquid, low priced and therefore easy to buy and sell, until they engineered a reverse merger. Bank of America eventually took that place.

 

When you are in HFT, you are basically looking at margins that are very very small. It could be one-tenth per penny for a transaction in the market-making business; therefore, you want to make sure that you are using your capital effective and efficiently.

 

That means speed traders will want to trade the lowest-priced instruments (e.g. Bank of America), as the profit stays constant for each transaction, and the percentage margin will be higher. That is why trading liquid and low-priced instruments becomes an important component of HFT.

 

As you can see from this comprehensive definition, not all orders generated automatically by computers can be called high frequency trading. Trading has to somehow include speed, co-location, limited overnight exposure, and highly-liquid instruments, to potentially qualify as high-frequency, in my opinion. My opinion will be different to the opinion of other experts, practitioners or academics; that’s why I think spending time in coming to a standard definition of HTF is wasteful; industry participants would rather discuss manipulative practices that can be facilitated by these technologies, and the best way to monitor and eliminate them from financial markets.

 

HFTR: This is a very fast-moving industry. What have been the most significant changes to the HFT landscape since your book "The Speed Traders" was published early last year? 

 

EP: From my point of view, the most dramatic change is happening in the U.S. equity markets (where it all started), with declining volumes for the 3rd straight year. As you can see in this recent post, http://thespeedtraders.com/2012/11/12/the-new-york-times-reports-declining-u-s-high-frequency-trading/, in my blog http://thespeedtraders.com, this phenomenon, coupled with the lack of volatility (reflected by the lower share of HFT participation in the volume), is negatively impacting the industry. HFT relies on volume and volatility; there are certainly macro factors that go beyond the equity markets, but this is pushing HFT firms that focused only in equities to explore other asset classes and monitor new geographies, as well as to develop services business leveraging their infrastructure in place.

 

Another important change in the last year has been the regulatory aggressiveness experienced by the industry in certain European countries with initiatives that have gone from financial transaction taxes to practically limitations to HFT activities. Any financial tax would conceivably be catastrophic for both high-frequency trading and the financial systems that adopt it. That would not affect long-term investors who exhibit low-turnover in their trading. But people in HFT who are relying on small margins to be profitable will be impacted by any transaction tax; let’s remember that for market-makers, margins may in the range of one-tenth of a penny per transaction. Any transaction tax will wipe out any margins there.

 

HFTR: What do you see as the biggest challenges facing HFT firms today? What about the wider industry?

 

EP: After the financial crisis of 2008, influential audiences blamed financial firms for it and part of that was focused on high-frequency trading. Therefore, they are assuming that taxing financial transactions will help solve many of the problems currently affecting the economy, as that would raise billions of dollars. My sense is that any transaction tax would be ultimately passed to investors and consumers; therefore, I don't think there is any efficacy in imposing transaction taxes. It is going to be difficult game as well; neither the US nor Europe will want to be the only block adopting the financial transaction tax, if they finally get to agree on a proposal. Ultimately, financial participants will just move somewhere else; financial authorities in Asian and Latin American markets will no doubt welcome them.

 

HFTR: Where are the main HFT opportunities today (in terms of asset class, geography, trading strategy, etc)?

 

EP: Given declining volumes in traditional asset classes in developed markets, it is only natural to expect players focusing on new asset classes and new geographies, employing multi-asset trading strategies. While there are additional costs and limitations in many of these emerging economies, players will be smart to monitor the evolution of the regulation in these geographies, and be ready to jump when the opportunity becomes available, which  will be reality sooner or later.

 

HFTR: How do you anticipate HFT-type trading strategies (such as electronic market-making, cross-market arbitrage, rebate capture, etc) will evolve in the face of increasingly restrictive regulatory proposals? 

 

EP: Low-hanging fruit strategies are characterized by limited shelf-life profits, and that has been the case with the most popular ones used by high-frequency traders. For instance, market making; the firms that were super successful in this game (e.g. GETCO) are continuing investing huge amounts of money merely to maintain their competitive advantage and at the same time trying to find new revenue/profit sources leveraging their expertise. Why? Declining volumes and declining volatility spell trouble for them. We are getting to the point that even rebate capturing strategies are under the microscope and risk continue being enabled by the exchanges, so the only alternative is moving to more IQ-intensive strategies that can be more sustainable in the long-term.

 

HFTR: From your perspective, which regulatory proposals make sense and which are ill-thought through and unworkable? Is there anything that regulators should be doing that they're not? 

 

EP: HFT, like any other areas of finance, should have sensible regulations imposed to promote sound trading practices and protect the average investor from predatory behavior. If a non-HFT market participant believes that he/she cannot enter into fair transactions then that individual will not invest in that market. To create that atmosphere of trust and effectively regulate global financial markets, regulators must be armed with the capacity to analyze trading activity in real time.

 

If HFT is predicated on speed, its regulation must also be built around the same requirement. Real time information will allow regulators to see everything that is occurring in the markets, no matter how quickly the order information is being posted and transactions are occurring. This will require significant commitments to invest in both human capital and information technology; however, it is vital for regulators to level the playing field of HFT in order to best supervise it.

 

Real time policing of the marketplace for potential malfeasance is the most efficient way to regulate HFT. Just a few months ago, the SEC missed an opportunity to move in this direction faster by approving a rule requiring exchanges and broker-dealers to provide trade information to a central repository by 8 a.m. the next trading day, as opposed to the original real-time reporting requirement. While either development would have taken years to be implemented, once in place it will have the potential to immediate alert and stop erroneous trading activity such as the one experienced by Knight Capital for 45 minutes on August 1.

 

HFTR: Have the markets (particularly the equity markets) become too complex for the majority of end-investors, in terms of proliferation of order types, proliferation of trading/matching venues, etc? What can/should be done about this increasing level of complexity?

 

EP: Complexity can be a blessing in disguise. It could be a blessing because investors benefit from the access to a number of different venues to trade, all of them competing with one another on price, time and service.  On the other hand, complexity brings unknown challenges, which can only be dealt with once they become known after an unexpected incident.

 

During the past four decades, a wave of innovation has reshaped the way financial markets work, in a manner that once seemed able to deliver only huge benefits for all concerned. But this innovation became so intense that it outran the comprehension of most of their actors, not to mention regulators. Now it is time to leverage this progress in tracking and monitor this complexity in real time, as the only way to guarantee that benefits all market participants with minimum disruptions.

 

HFTR: What do you see as some of the most disruptive technologies coming along in the financial trading space? 

 

EP: In an industry predicated on speed, the disruption will come from technologies that bring the communication latency to the minimum. While most financial services firms have relied on cable, there’s only a limit to the speed that can be achieved. In this regard, I am particularly excited about the application of microwave technologies to this challenge.

 

HFTR: Thank you Edgar

 

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