Financial blogs and more mainstream media have been burning with comment over the last few days, though little light has been shed. Whether defending the liquidity-enhancing virtues of HFT or damning it as the rise of the machine, the fire’s accelerant is the click-bait publication of Michael Lewis’ formulaic “Flash Boys”, the actual fuel is the crowd-sense of vultures circling aloft. The postponement of the Virtu IPO may be ascribed to unfortunate timing, the decision to cash in was less subject to capricious fate. Equally, Goldman’s Damascene conversion to relatively slow trading, its championship of IEX and its $6.47 bn. farewell to the NYSE, are unlikely to be influenced by publishing schedule previews. This is an interesting vantage point to look beyond the ill-informed, angel-demon debate- to assess the HFT phenomenon’s past and look to its future.
HFT’s many variants were born in the alchemical crucible of financial deregulation and exponential technological advance. This is not a new story- substituting pigeons for fiber-optic cables, being first to the news has founded and augmented fortunes from Caesar to the Rothschilds. Disruptive advance in communication technology is a feature of markets, HFT’s singular contribution has been to combine ultra-rapid information with algorithmic autonomy, fundamentally altering the market dynamic- we’re a long way from the coffee-shop. Reg NMS and Mifid I’s promotion of competition supercharged the evolution of HFT predatory parasites, the institutional herbivore’s response was to participate in dark pool trading, akin to huddling in the cave while the beasts prowl outside.
Although perhaps a deflating balloon rather than burst bubble, the brakes are being applied; the first-mover advantage of technological arms superiority is subject to Moores’ Law and the law of diminishing returns. More formal judges are also sharpening their axes: MiFiD II’s Article 17 proposed lockdown, Germany’s High Frequency Trading Act, the Italian FTT, the SEC\FBI ongoing investigation, the CFTC’s HFT TAC subcommittee and today’s confirmationof an investigation by the Justice Department – there may be trouble ahead. Typically, by the time regulatory reform marshals its battalions, the war has moved elsewhere. Five year falling volumes and revenues combined with the exit of two industry icons signal the end of the party, at least in the “traditional” algo markets- cash equity, futures and FX.
In theory, algorithmic trading can dominate any market where a liquid central limit order book exists. The mandatory proliferation of SEFs, block trading restricted and biased to smaller size trades, may have created a whole new hunting ground. Algorithms are currently used to refresh market-making quotes, to reset implied prices for package constituents and perhaps to execute orders; however, unsurprisingly, HFT‘s defining characteristic is the height of trade frequency. OTC derivative markets are glacially slow and trade count barely registers- the average number of trades through DTCC’s SDR for 2013 across all currencies, products and tenors was 1280, the vanilla benchmark products only averaged approx. 150- extremely low frequency trading. Higher trade counts could easily be achieved by breaking up a $100mn. IRS into 100 separate trades, however OTC derivatives are not fungible, and a portfolio of 100 trades is orders of magnitude more complex and expensive to execute, clear and administer. The architecture of the OTC markets is still firmly client-centric, heavily weighted to large participants trading slowly. While it may be a stretch to compare the post -crisis wave of regulation to the comet-impact extinction event that destroyed the age of the dinosaurs, we can be sure that its initial consequence will be profound, it’s second and successive order effects currently unforeseeable. With counterparty risk a bygone relic, drastically reduced transaction costs and competition-driven convergence with the swap futures markets; it is easy to see a derivatives landscape that may look highly congenial to HFT’s next generation, a landscape immune from much of the speed limiting new legislation. A flash crash reverberating across the tightly-linked fixed-income markets- cash, ETD and OTC derivatives would be the thrashing of a whale compared to the minnow-tail twitches of the equity markets.
 Possibly excepting CMS (although highly illiquid)