Unless you’ve had your head buried in the sand, you’ll know high frequency trading stormed onto the mainstream agenda this summer, catching the critical eye of the international press, public and regulators alike.
Ironically, the practice had already been going on for years.
Given HFT’s clandestine nature and dependence on closely-guarded trading algorithms, opinion on the subject was understandably divided from the beginning.
Critics said it gave the Street’s big players an unfair advantage over the little guy. Defendants, on the other hand, claimed the practice was no more than natural market evolution; the automation of the trader so to speak. Also that HFT was a umbrella term for a multitude of different strategies.
Rarely though did the world get a true picture of how HFT strategies and prop trading really work.
It was with great interest, therefore, that we picked up a call from bona fide HFT prop trader Irene Aldridge this week. Aldridge was doing the press rounds promoting her new book High Frequency Trading, out on November 25, which she said she was incentivised to write to dispel general misunderstanding about black-box strategies.
Yes, yes –just another apologist for industry, we hear you exclaim. Actually, we have to say, she offered some very interesting insights.
When small is better than big
Aldridge, you see, co-manages a five-person HFT shop out of New York and Toronto called Able Alpha. Her firm specialises in statistical arbitrage, event trading and liquidity provision strategies. Aldridge herself also offers consulting to foundations and other sell-side businesses eager to get into HFT.
In many ways Aldridge is what really defines the world of high frequency trading. Her firm is typical of the thousands of small proprietary businesses of no more than 5-10 people that are springing up across Europe and North America to take on the big institutional names at high frequency trading.
According to Aldridge the practice is now so pervasive and inexpensive that almost anyone with funds to invest and a knowledge of computer programming can gain access:
“You’ll be surprised, I get at least three emails a day from people working in computer science, simple programmers, asking for advice on how to build HFT strategies on their own time.”
And it is this world that Aldridge, whose market expertise originated in foreign exchange and futures, shines a light on well:
“Right now what we used to consider a super computer can cost as little as $300. And the reason costs have fallen so substantially is largely because of the gaming industry – it’s the same technology. Both computer games and HFT require fast processing speed, a lot of innovation has therefore stemmed from the gaming company producers.”
In fact, Aldridge suggests the industry is now in the midst of a “gold rush moment”.
The rise of cross-asset strategies
Of course, even a super computer can’t guarantee you profits without a successful strategy. Yet, it’s developments here that are really storming ahead.
Anything and everything now appears possible. While most people still equate HFT with equity trading, the reality says Aldridge is that it’s happening across all the major asset classes, and particularly so in foreign exchange, futures and options markets.
Even in fixed income, she says, traders are turning to on-exchange electronic dealing and calling for increasingly more products to go electronic just to gain algorithmic advantage.
Note the following chart from Thomson Reuters, which tells the story well:
Aldridge says it is also encouraging an increasing number of emerging market exchanges to go electronic.
As for the type of strategies being deployed, Aldridge says it’s “a bit of a wild west in terms of model development”. Everyone is experimenting, with cross-asset statistical arbitrage among the most popular new frontiers.
That, by the way, entails spotting synergies between everything from oil futures and dollar cross rates, to exchange-traded-fund index arbitrage — something which explains why the biggest holders of ETF shares tend to be HFT firms, and why they turn up so frequently as ETF authorised participants.
The smaller HFT protagonists, meanwhile, tend to orientate towards forex strategies, she says, because the ability to leverage up between 40-100 per cent means even someone with a small capital base can make substantial revenues using high frequency or algorithmic techniques.
But while it’s understandable for people to lament the demise of the old-school trader model, it’s wrong to suggest these developments are in any way sinister, says Aldridge. The super-computer revolution is happening because it’s just more cost effective to employ one programmer over dozens of expensive traders. It’s probably more efficient too. As she explains:
“HFT is nothing more than the automation of the traditional trader functions. It’s not doing anything that wasn’t already done. Even flash orders are just an automated version of those who used to sit on the exchanges and had immediate access to information. You had to pay a lot to put someone like that on the exchange.”
This, more than anything, she says is why the harshest critics tend to be brokers and market makers, whose jobs are being threatened by the fact that one of the HFT’s core strategies is liquidity provision. Not that Aldridge doesn’t sympathise with some of the arguments against flash trading itself.
Nevertheless, she actually predicts it will be OTC markets above others that will bear the brunt of HFT’s rise:
I think it’s allready happening, in fact. Over the counter products are becoming very niche and sophisticated, catering to high end clients as the deals don’t generate much volume and they’re labour intensive. They’ll become one-of-a-kind investments, not for the mass financial market.
That’s certainly a trend we can believe, given regulators’ belief that the unregulated OTC derivatives marketplace played a central role in the 2008 crisis.
In which case: fewer OTC securities = more electronic exchange-traded securities = more HFT.
Where fantasy finance meets the real world – FT Alphaville
When equities are not enough, HFT turns to FX and futures – FT Alphaville
HFT in commodity ETFs – FT Alphaville
Electronic trading and commodity prices – FT Alphaville