The End Of HFT?

"High-frequency trading, long an obscure corner of the market, has leapt into the spotlight this year. Wildly successful in 2008, high-frequency traders are the talk of Wall Street, attracting big bucks and some unwanted attention. Concerns that some traders are taking advantage of less fleet-footed investors has drawn the attention of regulators and members of Congress." - Scott Patterson of the Wall Street Journal

This quote, taken from the Wall Street Journal, was written only four years ago.  At the time HFT was the talk of the town and was attracting billions of dollars.  At its peak in 2010 HFT accounted for more than 60 percent of all the volume on US stock exchanges.  It appeared that it was just a matter of time before they took over the remaining 40 percent.  The worry was that these traders were going to make the flash crash look like a minnow in a shark's presence as when they market crashed (and it was sure to at some point), all of these traders would head for the exit at the same time potentially driving values to next to nothing.  So how is it that they are now in retreat?

First off let's get clear on what HFT is and how they make money.  HFT traders make money by arbitraging positions.  For example one of the first HFT traders used their ability to amass data from the market makers themselves prior to market opening.  Using this data they were able to determine the most likely direction of a stock's move at open before the market maker themselves could work it out.  In the few seconds after the open their computers would trade any shares where the opening quote was perceived to be marginally incorrect.  Once the correction was made they would then offload the position pocketing a small fortune off the small move.

Well back then this was revolutionary.  Within a few seconds and trading a spread of a few pennies billions were made.  This attracted a lot of attention and by 2009 HFTs traded roughly 3.3 billion shares a day and made $5 billion in profit but the spread was now down to a tenth of a penny a trade.  Once again the success of the strategy was their undoing.  By 2012 HFT trading was down to 1.6 billion shares a day and the spread had dropped to a twentieth of a penny.  Profits had dropped to $1 billion and the risk of the trade was increasing.  Furthermore in order to stay ahead of the competition HFT firms required faster and faster data feeds and this required being closer and closer to the exchange.  The exchanges themselves woke up to this and started to charge a massive premium for close access putting many a fund out of business.

The interesting point to me is that here is a classic example of the market at work.  Initially there was an opening and it was exploited for a massive profit.  This profit was produced as long as the spread existed but with competition the spread has been all but eliminated making it a better market.  With the lack of profit potential the funds are moving away and the threat has been reduced.  Fortunately there funds did not cause a massive sell off (although there were a few stocks that were hit temporarily) and the threat has improved oversight as authorities managed to keep abreast of the situation so it appears that the initial fear is gone and the market has sorted itself out without the usual government intervention.

Pity that this example is not used at the Federal Reserve who is bent on making sure that no pain is felt by creating a fictitious economic environment.  It would have been far better to have exited their assistance after the financial crises was averted and let the markets work themselves out but their continued interference has now created a massive problem and I am afraid that their lack of conviction and overly optimistic outlook will be their downfall.