High-Tech Hijinks

Short Circuit
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Wall Street’s HFT Profits Seem to Be Short-Circuiting

There’s a lot of focus right now on so-called high frequency trading on Wall Street these days. This kind of fast-paced computer-managed investing involves using an algorithm to move large sums of money around in fractions of a second, taking advantage of small price changes and theoretically generating big bucks for investment banks as a result.

Except lately, those bucks haven’t been so big.

A fascinating post in The New York Times this week about the decline of high frequency trading, or HFT, shows that trading via algorithm is not quite the cash cow it was in years past. According to the Times, HFT is set to generate only $1.25 billion this year, down 35% from 2011 and a whopping 74% below its 2009 peak of $4.9 billion.

Considering the big-ticket nature of investment banking, where a charges related to a $4.4 billion “London Whale” trading loss failed to sink JP Morgan Chase (NYSE:JPM) earlier this year, that seems an awfully small profit contribution in the grand scheme of things.

There’s also data in the article indicating that stock trading volume due to robots has declined from 61% of market activity to just 51% now, according to the Tabb Group.

So what gives? Are we winning the war against the evil investing robots? Have regulators finally begun to crack down on this fast-paced game that leaves many retail investors in the dust?

More Attention From Overseers

Well, regulators indeed are playing a bigger role. In the wake of the May 2010 “flash crash” that sliced 600 points off the Dow in just 20 minutes, and the Knight Capital Group (NYSE:KCG) trading “glitch” that burned $440 million in a half hour, there has been a clear focus on computer-driven trading and its risks to the market.

At home, the SEC just hosted a meeting last month to talk about ways to limit problems. There was also a Senate hearing, and a recent report by the Federal Reserve Bank of Chicago highlighted the very real concerns of market participants.

Across the pond, our friends in Europe are also taking a hard look at HFT and its impact on capital markets. The New York Times wrote in September that “countries around the globe are now using America as a model for what they don’t want to look like,” and EU lawmakers have been pushing a half-second delay on trades that sounds academic to retail investors but would undercut most high frequency trades.

‘Stalemate of the Spambots’

This attention is all very good for retail investors worried about the impact of HFT algorithms on their portfolio. But let’s not claim victory over the robotic traders just yet.

The fact remains that the biggest pitfall to high frequency trading profits has been breakneck competition between the robots themselves.

As The New York Times reports, “The technological costs of shaving further milliseconds off trade times has become a bigger drain on many companies,” and this arms race has resulted in many investment banks slowing down the scale of their HFT operations simply to stop the mammoth expense of maintaining and improving their matrix of robot trading algorithms.

Consider that Wired recently took a spooky look at the way technology is supplanting research as the tool used by Wall Street, unearthing a scheme to plant drones over the ocean to speed transmission time on trades by fractions of a second. What kind of expense would that incur, and would it actually be profitable? Technology has progressed so far that it would take a truly mammoth capital expense to get a competitive advantage, so Wall Street investment banks seem to be at loggerheads.

And as Felix Salmon of Reuters postulates, the rush of investment banks into the space has provided a limited opportunity now that everyone has the same arsenal of HFT tricks.

“Call it the Stalemate of the Spambots: the HFT algos are all so sophisticated, now, that they just ping each other with order spam, rather than actually trading shares,” Felix writes. “Naturally, if you don’t trade shares, you can’t make money. But at the same time, anybody who does trade shares risks getting picked off by the very algorithms which are increasingly circling each other like prizefighters who never land a punch.”

The Future of HFT

So where does that leave us on the future of high frequency trading?

Some market participants believe HFT should actually be embraced, since it increases overall market volume. And that’s true — because as the robot traders have pulled back in the last year or so, overall market trading volume has declined as well.

Jim Overdahl, an adviser to the Futures Industry Association’s Principal Traders Group, recently posited that “[t]rading costs are lower, markets are deeper and more liquid, and discrepancies in prices across related markets are reduced.”

Perhaps, but relative to what? It’s not like the markets were broken before our robot saviors came along. There are plenty of issues that trade a relatively small number of shares daily and nobody ever cries foul; Clorox (NYSE:CLX), for example, trades just 750,000 shares daily or so while larger consumer products companies Procter & Gamble (NYSE:PG) trades 9 million shares or so. Is Clorox a “low volume” stock just because it’s a lower-volume issue? Hardly. Would it benefit from 12 times the volume? Not necessarily.

So let’s not be a slave to market volume here and tie our fates to the robot overlords just to increase liquidity for limited benefit.

Other folks remain convinced that the secular decline in HFT profits and volume, coupled with regulatory focus in the short term, means that we have this problem pretty much licked.

But while the response has been decent thus far, it has hardly been comprehensive … and we are not 100% safe. USA Today recently wrote an editorial calling for more action, and even sophisticated investors such as billionaire Mark Cuban say they’re “terrified” by high frequency trading.

In short, this battle is far from over. While the evil robot traders may be on the retreat, we would be wise to not give up the fight just yet.

Because as history has taught us, all it takes is one rogue algorithm to send equities reeling. And one thing investors don’t need right now is another reason to fear or distrust this market.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he owned a position in Apple but no other stocks named here.

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