The topic of high-frequency trading has been batted around over the past few years more harshly than a birdie at a badminton game. It's no secret that HFT has been discussed globally across an unusually broad spectrum of professions: academics, regulators, Main Street and Wall Street. Regardless of your opinion -- favorable, unfavorable or something in between -- the view of HFT is often static. Many who follow the market hold the same views of the business as they did five years ago. However, like most businesses, HFT is dynamic. It evolves over time. Given that, it may well be time to ask if HFT has run its course in the U.S. equity market.
Businesses have a life cycle that consists of several phases, including the introductory phase, when a business starts trials and idea testing; the growth phase, when new participants flood the market to seize recognized opportunity; the maturity phase, when growth levels off as the participants saturate the business and opportunity declines; and finally the decline phase, when the business recedes as new opportunity is found elsewhere.
Business life cycles vary. In some industries the life cycle may span decades. In others, it may last only a few years. Think about brokerage in the capital markets. Securities brokers have existed for more than two centuries, and business expanded tremendously between the 1960s through the early 2000s before a somewhat precipitous decline after 2008. In contrast, consider video rental stores. VHS movie rentals were the rage in the early 1980s but were dying by the late 1990s with the rise of the Internet, readily available video recording technology and DVD storage formats.
High-frequency trading, despite the hoopla, may have blown through its life cycle in a brief five years. This doesn't mean that it's a nonissue or that rudimentary considerations for the traditional institutional trader aren't of concern. It may well mean that the magnitude of the challenges associated with HFT are, to a degree, receding. It also may mean that cutting-edge refinements and strategies are becoming more standardized and the business is also becoming better defined and more standardized.
Regulation NMS's Effect
High-frequency trading gained attention, if not notoriety, around 2008. It was during this period that market structure developments brought about by Regulation NMS implementation fostered rapid technology development. Regulation NMS brought market fragmentation, protected quotes at existing exchanges and required that privately developed electronic linkages be used to connect "fast" electronic exchanges. This led to opportunities across market centers for enterprising firms with quantitative and technological talent.
HFT early movers -- such as GETCO, Citadel and Wolverine Trading -- were able to realize considerable scale advantages not readily available to subsequent entrants. The so-called "race to zero," referring to the tremendous investment in latency-dependent strategies backed by considerable technology spends, was centralized among these few and perhaps some other firms. The barriers to entering the race-to-zero set subsequent HFT entrants on alternative paths to realize potential gains. This gave rise to virtual armies of data analysts across large, midsize and small firms looking for sustainable return opportunities.
[HFT Profits Shrinking? The Data Doesn't Lie]
The more crowded the HFT market, the more difficult sourcing sustainable profit-generating opportunities became. By 2011 we heard continuous discussion from participants that the length of time a particular strategy would work was on the decline. Now, declines in overall equity market volume and volatility have led to smaller firms exiting the business and larger ones cutting back on staff in the wake of profitability challenges. Certainly, firms in search of opportunities are increasingly pushing across markets and other asset classes. Nevertheless, HFT isn't what it once was -- even a few years ago.
High-frequency trading has evolved. In a few short years it has followed a standard business cycle and may well be heading toward decline. This doesn't mean it will extinguish itself or that non-HFT traders should abandon their concerns over the practice. It means that HFT practices, both good and bad, will become "institutionalized." In essence, as technology for oversight improves, issues will be more readily identifiable and less subject to rapid change. Accordingly, legislators and regulators should think twice and throttle back on knee-jerk changes to concerns about a business that might have been yesterday's news.