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High-Frequency Trading Is Changing for the Better

Aaron Brown

(Bloomberg Opinion) -- There’s been a spate of stories about the troubles of high-frequency trading firms. This is no temporary downswing. The factors that allowed successful firms to trade actively for a decade with seemingly no losing days are gone and there’s no reason to expect them back. Nevertheless, HFT will be as important a force in the market in the 2020s as it was in the two previous decades.

The key is to realize HFT is two things: latency arbitrage and liquidity provision. Latency arbitrage means getting an advantage by being faster. When an order comes to market at a good price, the fastest trader to take it wins. When prices move, the slowest trader to stop taking orders loses.

Of course, those two things are still true, but the arbitrage has gone away. The market for latency has become efficient. There are still advantages to faster software, faster hardware or co-location (putting your server next to the exchange computer to minimize transmission time), but the prices of those things have come in line with their values.

Therefore, the game has changed from pure speed to finding underpriced latency. This suits the skill set of hedge funds that know how to find things that are underpriced, and to do the necessary negotiations with exchanges and counterparties. Also, it carries significantly more cost and risk than old-fashioned HFT, so it requires capital. Traditional HFT firms were run and staffed by financial technology experts, with minimal capital.

But HFT was not only about speed. Being first is no advantage if you take a bad trade. HFT was also about executing the non-toxic trades (those that do not reflect any price-moving information) quickly at better prices than the best bid or offer, and rejecting toxic trades, which forces market prices to react more quickly and accurately to new information. This means lower costs and more efficient prices for non-informed investors—especially retail investors—at the expense of profits for traditional liquidity providers and traders with information not yet reflected in prices.

HFT-like techniques are now embedded into the market structure for liquid developed market stocks and the more active exchange-traded futures and options. It’s no longer a separate business, nor a source of huge profits.

So pure HFT is moving into other markets. Less liquid stocks and exchange-traded derivatives. Emerging markets. Bonds and over-the-counter derivatives. Structured products. The rewards for supplying liquidity in these markets are much larger than those available for liquid stocks, but the challenges are larger. It’s harder to get information about orders and transactions, and electronic execution may not be available. You have to be willing to hold positions longer as it may be weeks or months before another buyer or seller for a specific security comes to market. That in turn means you need to hedge, something traditional HFT shops either didn’t do, or did only in simple ways.

Speed is still important, but it’s internal, not external. Traditional HFT meant short time between an order coming to market and your ability to take it. It consisted mainly of external transmission delays, firms quickly learned to make their internal decision time so fast that it was insignificant to the outcome.

In the newer, less liquid markets, transmission speed is insignificant to the processing need to incorporate up-to-the-second information from a large variety of sources. Real-time processing with feeds that are known to be out-of-sync is tricky. Moreover, since hedging requires multiple trades to be executed—often in different venues—as close as possible to the same time, the complexity of the problem is much greater than buying or selling shares of a liquid stock.

For all the differences, these problems match the skill set and cultures of traditional HFT firms. They are fundamentally technology problems, although they require deep knowledge of the mechanics of financial markets, not risk/return maximization or negotiation problems. I expect these markets to interest the disruptive HFT firms of the 2020s, often descendants of, or staffed with veterans of, earlier HFT firms.

I expect a similar cycle as we saw over the last 25 years from equity HFT firms. They will likely be ignored until the profits are so big and steady, and the changes to the market so great, that notice is forced. There will be a decade or so of controversy, as the old liquidity providers and information traders throw up roadblocks to protect their profits. But investor interest will triumph. Latency will be priced efficiently, and liquidity will improve dramatically. Long live HFT.

To contact the author of this story: Aaron Brown at aaron.brown@privateeram.com

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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