During the past 10 years, worldwide capital markets have undergone structural transformations that have fundamentally changed the manner in which exchanges, brokers, dealers and investors conduct transactions in publicly traded securities. New trading systems and technologies have emerged that are so innovative and fundamentally different from their predecessors that market regulators, politicians
During the past 10 years, worldwide capital markets have undergone structural transformations that have fundamentally changed the manner in which exchanges, brokers, dealers and investors conduct transactions in publicly traded securities. New trading systems and technologies have emerged that are so innovative and fundamentally different from their predecessors that market regulators, politicians and analysts are having a difficult time keeping up with the rapidly changing environment. Previously unfamiliar and mysterious sounding terms such as “alternative trading systems,” “co-location” and “dark pools” have become the norm. Out of this evolving environment has emerged a trading strategy referred to as high frequency trading (HFT). As the name implies, HFT involves sophisticated programs running on very fast computers that conduct round trip market transactions at speeds measured in milliseconds (1/1000th of a second).
Certain commentators believe that HFT has been beneficial and has increased the liquidity of securities, reduced transaction costs and narrowed the price spreads between bids and offers. Others believe that HFT affects the stability of the capital markets and are concerned that HFT firms have an unfair trading advantage over other investors. Domestic and international market regulators, as well as the ever-increasing number of stock market exchanges, are currently establishing regulations and policies that will affect the future activities and operations of HFT firms. This changing landscape will have an impact on the future profitability, viability and value of such firms.
Determining the value of any trading firm, hedge fund or investment management firm can be difficult. The variety and complexity of activities and strategies of these types of firms are staggering. Determining the value of HFT firms can be particularly challenging due to their relatively recent emergence, the variety of trading strategies, the evolving competitive and economic landscape, the rapidly changing regulatory environment and the lack of publicly available data on transactions involving HFT firms. Let's look at these factors and see how they impact the value of HFT firms.
Algorithmic trading in electronically traded securities (also known as “algo trading” or “black-box trading”) has been around since the early 1990s. This type of trading involves the use of sophisticated computer programs and equipment to make trading decisions, submit market orders and manage those orders after submission with minimal human intervention. In the computerized trading world, algorithms are essentially computer programs designed to conduct statistical analysis and then execute and manage trades based on a defined set of instructions.
HFT is a form of algorithmic trading in which computers identify and execute market transactions at very high speeds. HFT algorithms are designed to analyze market data and capture trading opportunities that may open up for only a fraction of a second. HFT trading strategies typically involve very short-term positions in highly liquid securities that are electronically traded (for example, stocks, currencies and options). HFT firms typically make very small profits on each trade but conduct thousands of trades in a single day. During the last 10 years, HFT activities have substantially increased the overall trading volume of capital markets and now account for approximately 50 percent to 70 percent of all trading volume in electronically traded securities in the United States.
HFT firms compete with each other on the basis of computer speed and algorithm effectiveness. Consequently, a technological “arms race” of sorts has been underway among these firms in an effort to obtain the fastest computers and develop the best algorithms. The issue of computer speed has become so important among certain types of HFT firms that they're locating their computers as close as possible to the exchange computers to reduce the length of the wire between these two systems. This practice is referred to as “co-location.” To attract HFT activity, the New York Stock Exchange recently invested over $100 million in a co-location facility in New Jersey, specifically designed to meet the needs of HFT firms. Other domestic and international exchanges are developing similar facilities.
HFT activities have come under criticism for their influence on market stability. These criticisms intensified as a result of the “flash crash” that occurred on May 6, 2010, when the Dow Jones Industrial Average (DJIA) plunged about 900 points — or about 9 percent — only to recover those losses within minutes. It was the second largest point swing and the biggest one-day point decline on an intraday basis in DJIA history. The Securities and Exchange Commission (SEC) believes that HFT firms were partly responsible for the crash because they stopped trading activities, which deprived the market of much-needed liquidity at critical moments during the trading day and exaggerated the resulting stock price fluctuations.
In the aftermath of the flash crash, the SEC implemented circuit breakers designed to curtail volatile swings in market pricing. The SEC also prohibited the practice of offering to buy or sell stocks at prices not in line with market pricing and established rules banning "naked access" to the market. Naked access is when broker-dealers allow HFT clients to make use of their high-speed connections to the exchanges without pre-trade filtering or risk controls. The SEC and European Commission plan to introduce additional restrictions on HFT activities and operations, including naked access, in early 2012.
Overall HFT activity and profitability has generally declined since late 2009. However, this decline has less to do with regulation and more to do with changes in market volatility, and HFTs continue to be a force in the capital markets.
The principal drivers that affect the value of HFT firms are: (1) strategies, (2) market volatility, (3) technology, and (4) personnel.
Most HFT strategies generally fall within one of three groups: (1) market maker, (2) trading the ticker tape, and (3) statistical arbitrage. The market maker strategy involves placing limit orders for buying and selling a security to earn a piece of the spread between the bid price and offer price for that same security (bid/offer spread). The success of this type of strategy depends on high levels of market volatility and speed of execution. Market volatility is defined by the significance and rapidity of changes in security prices. As markets become more volatile, the bid/offer spreads tend to increase. Since the spread between the bid and offer prices are where market maker HFT firms operate, larger bid/offer spreads result in higher levels of profitability for these types of HFT firms. “Tumultuous Times, p. 47,” illustrates market volatility, as estimated by the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), and the Standard & Poor's (S&P) 500 Index for 2006 through 2011.
As illustrated in “Tumultuous Times,” the market was at historically high levels of volatility from mid-2008 through mid-2009. During this same period, the S&P 500 Index declined approximately 46 percent from 1,300 to 700. As you might expect, markets tend to be more volatile during periods of rapid decline. Consequently, market maker HFT firms can do quite well during declining markets. In fact, these firms made unprecedented profits during the mid-2008 through mid-2009 period. In addition to bid/offer spread profits, market makers also received rebates from the various exchanges for each trade executed. These two factors combined to substantially improve the profitability and value of HFT firms from mid-2008 through mid-2009.
Since mid-2009, market volatility has declined to historic levels of approximately 20 percent. With this decline, market maker HFT profits, and the associated business enterprise values of certain HFT firms, declined as well. Consequently, the 2008 and 2009 financial statements of an HFT firm can provide a distorted view of long-range expected financial performance. An assessment of the relationship between market volatility and profitability is critical to the valuation of an HFT firm. It's also important to remember that market volatility isn't necessarily correlated with market direction. In other words, HFT market makers can make money in both up and down markets.
As of the writing of this article in mid-September, the S&P had declined significantly and the VIX was once again on the rise. The S&P's downgrade of U.S. Treasuries, U.S. federal government budget battles, as well as uncertainty regarding the stability of U.S. and European economies, contributed to significant intraday market volatility. The CBOE reported the VIX in the high 30s to low 40s as of mid-September 2011 and HFT firms were once again reporting high levels of profitability.1
The ticker tape trading strategy is generally comprised of two categories: (1) filter trading, and (2) momentum trading. Filter trading involves monitoring stocks for significant or unusual price changes or volume activity. This strategy includes trading on announcements, news or other event criteria. Algorithms generate buy or sell orders depending on the nature of the information. On the other hand, momentum trading is when algorithms identify temporary imbalances in supply and demand for a security and quickly capitalize on that imbalance. This type of strategy is largely dependent upon the ability of HFT firm computers to process large amounts of information and effectively take advantage of very brief trading windows.
Statistical arbitrage may involve classical arbitrage strategies, such as covered interest rate parity in the foreign exchange markets, but may also include low-latency strategies. Low latency strategies are when HFT computer programmers rely on speed of trading execution to gain minuscule advantages through price discrepancies in a particular security trading simultaneously on disparate markets. Co-located computer equipment with state-of-the-art technology and efficient algorithms are important competitive advantages when using this strategy. Obviously, talented computer programmers are also a necessity to develop and maintain the effectiveness of the trading algorithms.
Valuing a business enterprise typically involves some combination of a market approach, asset approach and/or income approach. The market approach is based on an analysis of comparable firms that are either publicly traded or that were acquired by another firm. Unfortunately, the use of a market approach to value an HFT firm is difficult because of the lack of comparable publicly traded companies and the lack of available data on merger or acquisition activity involving HFT firms. Consequently, the market approach is typically not a viable method of valuation for an HFT firm.
As the name implies, the asset approach involves discretely estimating the value of a firm's assets and then adding these values together to arrive at the total value of the firm. The principal assets of an HFT firm are intangible in nature, such as the trained and assembled workforce, proprietary software and technological know-how. Certain HFT firms own their computer equipment; however, an increasing number of these firms are leasing due to the rapid pace of technological change. The asset approach is typically used to estimate the value of asset holding companies or companies that are in financial distress. HFT firms may hold positions in securities for short periods of time, but aren't considered asset holding companies. Unless the HFT firm is in financial distress, the asset approach is rarely used in the valuation analysis.
The income approach involves the projection of revenues, expenses and cash flow adjustments to estimate the future cash flows of the HFT firm. These future cash flows are then discounted to estimate their value as of the appropriate valuation date. It can be difficult to project an HFT firm's future cash flows because the HFT environment is rapidly changing, algorithms are becoming functionally obsolete, capital market regulators are constantly intervening and future capital market activity and volatility are hard to predict. Despite these difficulties, the income approach is the one most often used to value HFT firms.
When using the income approach, the analyst prepares a projection of future income statements that are then used as the basis to estimate the future cash flows of the HFT firm. The projected income statements are comprised of revenues, expenses, taxes and cash flow adjustments. These components are interrelated and require analysis to properly estimate the projected cash flows of the HFT firm. The primary components of projected cash flows are:
- Gross and net trading revenues
- Base and bonus compensation
- Operational expenses
- Income taxes
- Net capital requirements
- Capital expenditures
- Discount rate
Gross trading revenues are derived from trading activities in defined classes of securities. For example, the subject HFT firm may be trading in equities, futures contracts and options. Trading activities in these securities will typically have different levels of activity, profitability and growth. Understanding the activity level of each class of security and future strategic plans of the HFT firm will assist in projecting future performance. The analyst should discretely analyze each class of security because of its unique effect on other components of the income statement. (More on that relationship later.)
The difference between gross trading revenues and net trading revenue are expenses and fees associated with trading activity. Different securities are subject to different levels of trading expenses and fees. Consequently, it's important to understand the various classes of securities that the HFT firm is trading and whether future changes in trading related expenses or fees are foreseeable. Also, the HFT firm may be considering a move into an entirely new class of securities that will affect the nature of the trading expenses and the risk profile of the firm. When preparing projected income statements, the analyst should review the historical trading expenses of each class of security, analyze any expected changes in the makeup of the classes of securities to be traded and properly project the expected trading expenses associated with current and projected trading activities.
A core asset of an HFT firm is its personnel. Consequently, employee compensation is typically one of the most important and significant expenses of an HFT firm. Many HFT firms have bonus calculations based on bottom line financial performance. The trigger points of these compensation programs should be understood so that expenses can be accurately projected in a manner consistent with the firm's expected financial performance.
Operational expenses of HFT firms are typically more fixed than variable in nature and thus more easily predictable. The analyst should consider the nature of the facilities in which the HFT firm resides and whether there will be a need for a relocation to accommodate future expansion. Moreover, the analyst should consider whether technological changes, including co-location costs and lease versus buy decisions regarding computer equipment, would change the historical cost structure of the firm.
Most HFT firms are organized as pass-through entities such as limited liability companies (LLCs). As such, HFT firms are subject to different entity level and shareholder level income tax attributes than C corporations. In addition, the income of an HFT firm may be subject to favorable tax treatment under Internal Revenue Code Section 1256. Under this section, capital gain income is taxed as either short-term (to the extent of 40 percent of such gains) or long-term (to the extent of 60 percent of such gains). This tax treatment is important because short-term capital gains are taxed at ordinary income tax rates, while long-term capital gains are taxed at the lower capital gains tax rates. Since HFT firms may earn a substantial portion of their income from buying and selling securities, the Section 1256 tax treatment can have a material effect on the income tax attributes of the firm. The Internal Revenue Service Schedule K-1 of the owners of the HFT firm provides the relevant classifications of income and should be reviewed to determine the appropriate income tax attributes of the HFT firm.
HFT firms are required to maintain certain capital requirements, prescribed by The Financial Industry Regulatory Authority (FINRA), to trade in securities. These regulatory issues are significant and can affect the amount of cash flow available to the owners of the HFT firm. The relative risk of the securities (referred to as “value at risk” or “VAR”) that the HFT firm is trading plays an important role in determining the net capital requirements imposed. It's important for the analyst to work with the chief financial officer and the head of trading of the HFT firm to understand the relative risk of the securities the HFT firm expects to trade and the net capital required to be retained by the firm to trade in those securities. To the extent that additional net capital is required to conduct projected trading activities, the analysis should reflect the diversion of cash flow from the business owners back into the HFT firm's net capital requirements.
The capital expenditures of an HFT firm may be important if the firm has decided to own, rather than lease, its computer equipment. This element will impact either the operational expenses (in the case of leased equipment) or the cash flow adjustments (in the case of purchased equipment). The rapid pace of technological change in the computer industry requires HFT firms to constantly update their computer equipment and algorithms. Consequently, the analyst must adequately project the operational lease expenses or capital expenditure cash flow requirements for technology assets. Failure to do so will result in an overstatement of the available cash flows of the HFT firm.
In the income approach, the discount rate is used to calculate the value of the projected cash flows of the subject company as of the valuation date. The discount rate contemplates the risk of earning those future cash flows as well as the impact of inflation and the time value of money.
The determination of the discount rate for an HFT firm can be tricky. Most of the information used to estimate discount rates is derived from the investment rates of return of publicly traded companies. Since there are no “pure-play” publicly traded HFT firms, the discount rate must be derived from more generalized studies of publicly traded and privately held firms. Two of the better sources for discount rates for HFT firms are the Duff & Phelps LLC Equity Risk Premium (ERP) reports and the Pepperdine University Private Capital Markets Survey (PCMS) reports. The ERP reports don't specifically address HFT firms, but they contain information that allows the analyst to estimate the discount rate based on other financial or operational characteristics. The PCMS reports address the discount rates of private companies based on surveys of private equity and venture capital firms. Since HFT firms are often in the early stages of development and the projections are subject to substantial risk attributes, discounts rates derived from private equity and venture capital firms are often useful in estimating the appropriate HFT firm discount rate. The additional benefit of using the PCMS report data is that much of it is derived from other pass-through entities such as LLCs. Consequently, the tax attributes of the discount rate and the cash flows of a pass-through entity HFT firm are consistent.
The income approach for an HFT firm typically produces a controlling interest indication of value. Therefore, if the assignment is to estimate the value of a fractional equity interest, the analyst should consider the application of valuation discounts for lack of control and lack of marketability. The magnitude of these discounts is partially dependent upon the cash flow generating capacity of the HFT firm and the level of distributions that are expected to be paid to the owners. Since many HFT firms are in the early stages of development, the ability of such a firm to distribute cash may be questionable. Cash may be required to meet net capital requirements, purchase computer equipment and develop and maintain algorithms. In addition, employee compensation and bonuses can have a material effect on the ability of the firm to distribute cash to the owners. Consequently, the analyst should consider the ability of the HFT firm to make distributions when estimating discounts for lack of control and lack of marketability.
Determining the value of an HFT firm can be challenging, due to the variety and complexity of the activities and strategies of these types of firms. Moreover, the evolving competitive and economic landscape, rapidly changing regulatory environment and the lack of publicly available data on transactions involving HFT firms create additional valuation challenges. The market approach and asset approach are difficult to employ in the valuation of an HFT firm due to the lack of available data and the relevance of the analysis. Consequently, the income approach is most often used to value these types of firms. Working with the management of an HFT firm can provide substantial insights into the strategic direction of the firm, the revenue and expense relationships and the probability for success of future operations. At the end of the day, as with most companies, the value of an HFT firm is attributable to its ability to distribute future cash flows to its owners.
- See “High-frequency Traders Profit Amid Market Turmoil,” The Wall Street Journal, Aug. 10, 2011.
Daniel R. Van Vleet is a managing director in the valuations and financial opinions group in the Chicago office of Stout Risius Ross, Inc.