The rise of high-frequency trading has been as controversial as it has been meteoric. But there are signs that the bubble may have already burst for this new breed of activity – just as it has come under increased scrutiny from regulators and politicians on both sides of the Atlantic.
A report published in March by consultancy Aite Group found that high-frequency traders - who buy and sell securities across exchanges in a fraction of a second - account for 25% of equity trades in Europe. This figure is expected to rise to 45% by 2012. However, low levels of trading activity in the wake of the financial crisis and the high cost of investing in the systems needed for high-frequency trading are combining to hit the bottom line of trading firms. The forecasts of inexorable growth are starting to look at risk unless high-frequency traders can alter their tactics and their business models. Niki Beattie, a driving force behind alternative trading venue Turquoise as Merrill Lynch's head of market structure, and founder of consultancy Market Structure Partners, believes that Europe's trading markets are going through a period of evolution. She said: "The whole industry is going though a massive change - there are too many exchanges, too many trading venues and too many trading firms. The good times are over and we are now starting to flush out the winners and losers." That process started last year as trading volumes collapsed. The financial performance of Europe's largest high-frequency traders, which includes the subsidiaries of two US electronic trading firms, Getco Europe and Citadel Securities Europe, as well as the Amsterdam-based trading firm Optiver, have been telling. In 2009, net profits across these three firms fell by an average of 67%, while their trading revenues fell by an average of 49%. Optiver was the biggest casualty, with its net profits falling by 97% to €6.3m in 2009, while trading income fell by 63% to €264m, which it attributed to "challenging market conditions" in its 2009 annual report. These firms are loath to define themselves as high-frequency traders and prefer the term marketmaker. However, like some trading desks at investment banks and hedge funds, they use computer-driven strategies to trade securities across electronic exchanges in a fraction of a second. And there's no doubt that they also look to prosper through quick-fire methods such as statistical or latency arbitrage, which involves profiting from minute discrepancies in a share's price across different venues. These strategies have suffered as volumes have fallen away - the total value of European equities trades fell by 34% to $8.4 trillion last year, according to data from Thomson Reuters - and activity looks set to be even lower this year. The reason for the large drop-off in high-frequency trading profits is largely because the firms that conduct it are almost entirely dependent on trading revenues, and they need both volume and volatility to profit from this activity, both of which have fallen away, according to Hirander Misra, chief executive and co-founder of software vendor Algo Technologies. He said: "We are entering a phase of uncertainty, which will force natural selection to a certain extent. Low volumes and relatively low volatility are causing sub-optimal and stagnant markets." The costs of sustaining a competitive advantage over rivals is also serving to keep costs high in spite of lower trading activity. Peter Randall, chief executive of the alternative execution venue Equiduct Systems, said: "These firms need to be continually investing in faster, better systems to remain ahead of the market, but if these costs are rising at a higher rate than trading returns, then you have a problem." In a sign of the pressure on margins, the average ratio of trading expenses to trading income across Getco Europe, Citadel Securities and Optiver rose from 62% in 2008 to 83% last year. Randall also added that a lot of these firms had been building up their staff to sustain their pre-2008 growth, which has further added to costs. Getco Europe increased its headcount from 19 to 31 during 2009, according to its accounts, while Optiver added 23% to its staff in 2009, to "prepare for more growth", according to its annual report. However, and no doubt to the delight of these firms, the term high-frequency might be turning into something of a misnomer, according to Misra, as speed - or latency - was no longer a defining factor for success. He said: "High-frequency traders need a more sustainable business model than one based on latency alone; the differentiator lies with the quality of the firm's individual algorithms - speed is one of a number of factors." The most successful high-frequency traders are looking to sustain their businesses in new ways and move away from trading on their account. Beattie said: "The stronger marketmakers will expand their offering and compete with the investment banks in retail and institutional flow." This is already happening, as Getco launched its own execution platform, Getco Execution Services, in the US in 2008, which allows investors to trade anonymously in its pool of shares. It confirmed in April that it will open a similar venue in Europe this year. Citadel bought alternative execution venue Equiduct Systems from Börse Berlin last year and is looking to develop the platform as a venue for retail flow. Meanwhile, Optiver established The Order Machine with Dutch retail bank BinckBank in June last year, which allows BinckBank's retail customers to trade in shares listed on the Amsterdam Stock Exchange. Tom, as it is known, went live this month. And it appears that regulatory scrutiny on the activity is receding. Critics argue that high-frequency traders profit at the expense of other investors through dubious trading techniques and are short-termist in their attitude. However, the issue appears to be falling down the regulatory agenda, and two weeks ago regulators in the US excused high-frequency traders from blame for the flash-crash in the US markets on May 6, when the Dow Jones Industrial Average fell more than 900 points in the space of minutes. An errant buyside trade was identified as the cause. Regulation might in fact be beneficial, according to Misra, if it forces more types of over-the-counter contracts on to electronic exchanges. Misra said: "As one door closes, another opens. The move toward exchange-traded derivatives may well present opportunities for high-frequency traders. While the big fight over the last few years has been for equities flow, the next battleground will be in derivatives for both exchanges and trading firms." The party might not be over, then. It could just be moving to a different venue.慬