As any industry or even relationship extends over time, it evolves, changes. The criteria for what was acceptable or drove success in the early stages of development becomes more nuanced if not outright discarded. Such is the plight of high frequency trading and the market making industry. Here perhaps at a speed never before witnessed in history the rules of the game are being re-written and winners and losers trade places at microsecond speed.
New Tabb Group analysis reviewed by ValueWalk considers how the advent of the “IEX Speedbump” and other methods to slow down trading are creating both opportunities and challenges. In a US Equities report titled “Speed II: Have We Reached a Tipping Point?” Tabb Group founder and CEO Larry Tabb points to a new competitive advantage. The next competitive stage is not about greater speed – most high frequency trading players and even now certain institutional investors have all hit relative bottom – the future industry wave is about speed in analyzing information about speed.
Regardless of human or computer, the speed at which information could be accurately assessed drove success
To understand what is occurring in high frequency trading it is best sometimes to recognize the components of market structure that remain true regardless of human pit or electronically traded market.
At its most important level, markets, like a good investment thesis, have core performance drivers that are understandable and recognizable.
Human trading pits were populated by a special type of person, almost a freak of nature from one perspective. They had a mathematical mind to quickly calculate relative value market analysis, consider performance drivers, and in an instant calculate the fair value. This occurred with stocks and, more complex, derivatives, where future time value is an important formula component.
Ultimately the winners in the human trading pit where those that were not only quickest but their freakishly fast math was reasonably accurate.
Another component of the human pit was found on a more visceral level. Not only were the pit traders expert at calculating if / then problems with multiple formula variables quickly, but they understood how power worked. A trading pit was akin to a hockey locker room where strong human friendships were made and an aggressive, king-of-the-hill game was played out on a daily basis.
One of these features remained an important component of the new electronic trading landscape, one did not make it.
High Frequency Trading – Raw speed, like brute force, is losing to intelligence
Market opportunities are once again changing. Initially sophisticated HFT computer technology essentially reduced the time by which a market maker could calculate complex inputs from around the world.
The primary advantage that separated winners from losers was raw unintellectual speed. A relatively solid if-then calculation would reward those market participants who recognized the opportunity and were able to move mostly quickly to snatch it.
This is now changing, the Tabb report highlights.
“While time always seems to be getting faster as we age, in trading this is demonstrably true” Tabb wrote. He notes that in addition to raw speed, speedy data analytics is more important as relative latency parity has been achieved. “To enable the market to better understand time, meta-speed will become increasingly important. Information about speed will be almost as important, if not more so, than speed itself.”
This battle will once again re-define the landscape in what can be argued is the industry where speed and computer technology has impacted humans the most.
Institutional investors are not best served by inconsistent block order fills
High frequency trading has pros and cons, with some of the underbelly and charges of a “rigged market” most notably coming from author Michael Lewis, a point Tabb makes in the report. And it is her Tabb points to an opportunity to better serve institutional investors.
The report points out that HFT has dramatically lowered execution time and cost for smaller retail orders – even with alleged “front-running” high frequency trading tactics. Yes, certain HFT firms may be able to see an order and trade ahead of it, but the cost of trading has been reduced dramatically. Certain players recognizing what orders were coming into a trading venue – be it human pit or electronic – have always existed. The result has been lower costs to retail investors – but institutional investors and their larger orders remain problematic.
Consistent fill execution on large orders remains elusive as the liquidity size and consistency is more geared to the retail investor.
Enter the speed bump and moves to better serve institutional investors.
High Frequency Trading – +Multiple methods to reduce speed are being viewed from the perspective of providing a benefit to larger investors
Those most disadvantaged from the market’s increasing speed variable are “firms investing in similar strategies across similar time lines,” Tabb points out. More specifically, not just crowded strategies, but those strategies that trade in shorter time horizons – one year versus one month, for instance – are more negatively impacted by speed.
The speed equalizer – particularly for larger institutional investors with block orders – are speed reduction methods. More than just the famous “IEX speedbump,” firms such as the Chicago Stock Exchange and Chicago’s PDQ ATS are offering auction models to attract larger liquidity bases, the report noted. Canadian trading venues Aequitas NEO Exchange, TSX Alpha and the Toronto Stock Exchange, meanwhile, are following the IEX model and implementing speedbumps. In some cases these systems do not strictly adhere to the “first in, first filled” exchange mantra but rather provide larger and more consistent liquidity.
“Speed bumps pause matching schemes to reduce the influence of high-speed liquidity takers,” Tabb wrote.
Increasingly in the new high frequency trading battleground those trading firms that can most quickly and intelligently analyze the market are the winners. Some concepts have not changed from pit to electronic, it is just the speed at which it is analyzed and the number of input variables that might have changed the most.