Beyond HFT

Last week I attended the Tokyo Financial Information Summit, put on by Interactive Media. The event was interesting from a number of perspectives. This event focuses on the capital markets; attendees are usually domestic sell side and buy side firms and vendors, including global firms active in Japan. This year there was good representation from around Asia ex-Japan as well; possibly attracted by the new volatility in Japan’s stock market. The new activity in the market was set off by the government’s Abenomics policies aimed at reinvigorating the Japanese economy. But I suspect the fact that Japan’s stock market is traded on an increasingly low latency and fragmented market structure gives some extra juice to the engine. Speaking of high frequency trading, Celent’s presentation at the event pointed out that HFT volumes have fallen from their peak (at the time of the financial crisis) and that HFT revenues have fallen drastically from this peak. In response to this trend, as well as the severe cost pressures in the post-GFC period, cutting-edge firms seeking to maintain profitable trading operations are removing themselves from the low latency arms race. Instead, firms are seeking to maximize the potential of their existing low-latency infrastructures by investing in real-time analytics and other new capabilities to support smarter trading. HFT is not dead, but firms are moving beyond pure horsepower to more nuanced strategies. Interestingly, this theme was echoed by the buy and sell side participants in a panel at the event moderated by my colleague, Celent Senior Analyst Eiichiro Yanagawa. Even though HFT levels in Japan, at around 25 – 35% of trading, have probably not reached their peak, firms are already pulling out of the ultra-low latency arms race–or deciding not to enter it in the first place. The message was that for many firms it is not advisable to enter a race where they are already outgunned. Instead they should focus on smarter trading that may leverage the exchanges’ low latency environment, but rely on the specific capabilities and strategies of a firm and its traders. Looking at this discussion in a global context, it seems interesting and not a little ironic that just as regulators are preparing to strike against HFT, the industry has in some sense already started to move beyond it.

Observations on HFT

High frequency trading (HFT) has been in news recently, especially after the US stock market crash, also called ‘Flash Crash’ of May 6, 2010 which created sudden panic in the market for a few minutes. Many have blamed high frequency traders and rogue algorithms for suddenly pulling out liquidity, reacting to uncertainty in the market. “Quote-stuffing”, a phenomenon where traders place large rapid-fire orders and cancel them immediately, was highly criticized as a major factor. The debate over the impact of high frequency trading on market stability has invited the attention of the regulators, who are currently assessing the impact of HFT on the market microstructure and gathering opinions of industry participants. Academic research investigating the role of HFT has not clearly reached a conclusion on whether HFT is good or bad for the markets, and there are arguments on either sides of the table. Those in favour of HFT say that it adds liquidity to the market, reduces spread and helps in ironing out price inefficiencies. Those taking the counterview say that HFT reduces book depth, it is unfair to market participants who cannot invest heavily in sophisticated technology, and it contributes to increased volatility. Notwithstanding the arguments over curtailing the freedom of HFT traders and asking for mandatory reporting among other measures, HFT as a trading paradigm has evolved during the last five years, with adoption rates constantly going up. Celent estimates that about 55% of all equities volumes are driven by HFT in US, the number is around 35% in Europe and around 5% in Asia, as shown in Figure. The rise of HFT in US and Europe was driven by regulations such as RegATS and RegNMS in US, and MiFID in Europe which spurred greater innovation in technology. Asia is now being touted as the next growth driver for HFT. Asia has taken to the adoption of HFT rather slowly, much of which can be attributed to the regulatory environment. Japan is an exception, however. Celent estimates that the percentage of equities volumes driven by HFT in Japan is around 30%. The reason is increased fragmentation in the Japanese equities market, coupled with adoption of sophisticated technology. Tokyo Stock Exchange’s adoption of high-speed Arrowhead trading system is a case in point. Japan is an interesting case, because the increase in HFT adoption coincides with increasing spreads and increasing volatility. However, this should not be understood as an insight about how HFT will unfold in the rest of Asia. The market for HFT in US is maturing, and Europe is also headed in that direction, which is why investors could look towards Asia and emerging markets for future growth opportunities. Added to this is also the concern about over-regulation in the Western markets. By maturity, we mean the increased standardization in HFT techniques and reduced diversity in trading strategies to capture unique trading opportunities. Trading firms and even trading venues are dealing with this by adopting sophisticated technology which may be cost intensive, such as upgrading hardware and software for achieving the least latency, for instance. This battle to achieve near-zero latency is not a feasible method for winning the market because of the costs involved. Therefore, the strategy for winning the market in the matured Western markets is moving towards “effective trading strategy generation”, and development of proprietary trading strategies which can be implemented with the existing trading and connectivity infrastructure. Japan and Australia are leading the trend in APAC, followed by Singapore, Hong Kong and Taiwan. China and India are important markets for HFT in Asia, but success will depend on how trading firms find their ways in dealing with the regulatory environment in both countries. Last year, China toughened its regulatory stance on speculation on futures exchanges. The exchanges have increased monitoring of “quote-stuffing”, which was mentioned earlier, and keeping a close watch on investors trading between their own accounts. In India, there have been some healthy signs for HFT. Both the BSE and the NSE have installed new co-location centers, and regulators have allowed ‘smart order routing’ paving the way for increased automated trading. Celent estimates that the percentage of cash equities volumes driven by HFT in India is around 5%. Another encouraging sign is the setting up of a cloud model which offers shared IT infrastructure by NSE. This is a boon to smaller players who do not have the capability to invest in private infrastructure. Instead, they can now plug into the infrastructure provided by NSE and get onto the HFT highway by paying a fee for the services availed. Overall, the signs for growth of HFT in India are positive. There is an interesting pattern that is emerging in relation to cross-asset correlations between asset classes over the last five years. Cross-asset correlations, especially in the developed markets have increased at an alarming rate. What this effectively means is that, portfolio diversification and other hedging techniques are way less effective today in protecting from unexpected price movements, than they were five years ago. There is a peculiar relationship between the increase in multi-asset trading and high frequency trading with increase in cross-asset correlations, which is being investigated. Consequently, alpha generating opportunities in the developed markets have dwindled. Despite the heterogeneity in Asian markets and the several challenges such as regulation, cost of borrowing and liquidity, there is more reason for investors to look towards Asia for future growth opportunities in HFT.