By Annie Massa and Charlotte Chilton (Bloomberg)
High-speed traders have hit the wall.
Even as critics of high-frequency firms have argued their speed and technology give them an unfair advantage, the traders are facing diminishing returns. For one thing, there’s been relatively little turbulence in this bull market, a challenge for high-frequency traders and other market makers because it restrains volatility and trading volume, curbing their profits.
“It’s not going to come back,” said Richard Johnson, a market structure and technology analyst at Greenwich Associates LLC in Stamford, Connecticut. “For a few years after the crisis, people were in denial and kept their business running as it had been. It’s not going to get back to that level, people have to accept that.”
That’s created an identity crisis for the fastest traders, forcing companies like Virtu Financial Inc. to seek out new businesses and pushing others out entirely. One stat helps boil it all down: Market makers in U.S. stocks produced $1.1 billion in revenue last year, compared with $7.2 billion in 2009, according to estimates from Tabb Group LLC.
Their struggles matter because market makers help investors buy or sell when they want to. The cutting-edge of market making now centers on high-speed data transmission -- beaming information across oceans with underwater fiber-optic cables and across continents with microwaves; in a bygone era it was people jostling for position in a trading pit.
Virtu, a New York-based firm that trades more than 12,000 securities and other financial instruments on over 235 markets around the world, is at the vanguard of automated trading, yet it’s embarked on a potentially company-altering acquisition. It’s buying rival KCG Holdings Inc. for about $1.3 billion, bolting on a company with more than five times as many employees.
One allure of the deal is KCG’s salesforce, which Virtu plans to deploy toward persuading other traders to license its state-of-the-art technology. Virtu already has a deal that allows JPMorgan Chase & Co. to access the Treasury market with its systems. Virtu Chief Executive Officer Doug Cifu and Bob Greifeld, Nasdaq Inc.’s former CEO who will become Virtu’s chairman after the KCG deal closes, see potential for the company to build a larger business selling trading technology.
Profit at Virtu has come down from its peak, with net income dropping to $158 million last year from $197 million in 2015. Its shares trade below the company’s initial public offering price of $19. Virtu fell 0.3 percent to $16.80 at 10:01 a.m. New York time Thursday.
High-frequency traders use advanced technology and a deep understanding of the electronic marketplace to carry out or cancel trades. As regulation introduced in the early 2000s drove the U.S. stock market into the electronic realm, the strategy paid off. But they watched the cost of managing their complicated networks climb -- which have grown to include investments in microwave towers and the fastest proprietary data sold by exchanges. Some firms say they’re reaching a point of diminishing returns in the arms race for the fastest networks, while others are doubling down on speed as a tool.
Getting Squeezed
“The pure speed trades are squeezed on two sides, by rising cost of infrastructure and low volatility, which gives you less reward for being the fastest,” said Eric Pritchett, chief executive officer and head of risk at Boston-based electronic trading firm Potamus Trading LLC. “That doesn’t mean there’s not still a big prize if you’re the winner. So it ends up being a better opportunity for the few firms who remain in it.”
The squeeze is also pushing trading firms to scout new revenue opportunities.
“High-frequency traders will move into areas they weren’t in before,” said Ari Rubenstein, co-founder of Global Trading Systems LLC, one of Virtu’s competitors. If you’re an executive at a speed-trading firm in this environment, he added, “you better be coming up with things outside the box.”
Rubenstein’s company last year bought a business on the floor of the New York Stock Exchange, where it shepherds the stock of publicly traded giants including Berkshire Hathaway Inc. and Twitter Inc. He said the purchase will give his firm the chance to offer other services directly to those companies, such as opportunities to trade foreign currencies and Treasuries, to help them hedge risk on their balance sheets.
The degree of the market’s doldrums is striking. The CBOE Volatility Index -- better known as the VIX -- sank to a 23-year low on June 2, showing investors see continued calm. Coupled with the rising cost of the technology that they need to do business -- like fast-moving streams of data -- several firms have pursued deals this year.
Teza’s Exit
Teza Technologies LLC shifted away from trading to focus on its hedge fund, selling some technology assets to Quantlab Financial LLC. “It is quite clear, on the whole, that making money in HFT has grown more difficult,” Teza said in a statement. “Our firm sees its future in the investment management business.”
Interactive Brokers Group Inc., a broker that helped invent electronic trading, sold its options market-making business. The company “continues to focus on bringing the latest technological innovations to clients in other areas of our business, which are expanding rapidly,” it said in a statement.
Chopper Trading LLC, a Chicago-based speed trader, sold assets to DRW Holdings LLC in 2015.
Just this week, Crain’s Chicago Business reported that proprietary trader Mocho Trading LLC closed up shop after opening about a year ago. Mocho Trading didn’t immediately return requests for comment.
Wanting Goldilocks
High-frequency traders want “a Goldilocks market with just the right amount of volatility,” said Jim Angel, a professor at Georgetown University in Washington. “They don’t want to see a flash crash kind of day, they want just enough of things happening so that people change their minds and want to trade.”
Fierce competition among high-frequency traders also batters their profits. Several are jockeying to position their microwave communications towers as close as possible to the data center used by CME Group Inc., owner of enormous futures exchanges, outside Chicago. In that battle, using the fastest data transmission equipment for just a few extra feet matters.
“The firms that are going to be successful have optimized their business, they’re lean and can make profit in this environment,” said Greenwich’s Johnson.
Even exchanges are taking notice of how record-low volatility is affecting high-speed traders, who are part of their customer base. Nasdaq CEO Adena Friedman said in April that the New York-based exchange operator is already contemplating potential effects from deals including the Virtu and KCG tie-up, which could effectively eliminate one customer for the data feeds it sells to traders.
“Consolidation in HFT could have some impact on our, maybe, data and connectivity services,” Friedman said on a quarterly earnings call with analysts. “We don’t think there will be a significant impact on Nasdaq,” she added.
To navigate these challenging times, HFT firms have “to be as efficient as possible, where they are trying to control their costs as best they can,” said Richard Repetto, an analyst at Sandler O’Neill & Partners LP. Low volatility is “a market condition they have to deal with,” he added.
