Digital technology has disrupted many an industry over the last few years, but perhaps none more so than the business of trading stocks.
High frequency traders tripled their share of the U.S. equity market from 20 percent in 2005 to 60 percent in 2008, although that share has since fallen to about 53 percent, according to RBC Capital Markets. Using high-speed, fiber-optic networks and sophisticated computer algorithms, traders can execute orders at speeds that were unthinkable just a few years ago. “We have found that anything north of 500 microseconds just isn’t fast enough,” says Rich Steiner, head of market structure strategy at RBC. That technology has driven many changes in the equity business including altered margins, new liquidity and trading patterns, and the rise of alternative exchanges, to name just a few.
Market experts say the dramatic changes that have occurred in the equities world are about to repeat in other markets such as bonds, derivatives, commodities and currencies, where much business is still transacted over the telephone or via nonpublic electronic venues and where prices are not fully displayed. “High frequency trading is going to transform many once bespoke markets, just the way it changed equities,” says Ciamac Moallemi, associate professor of decision, risk and operations at Columbia’s Graduate School of Business.
Multiple forces are pushing high frequency trading deeper into new territory, and for reasons that are very different than those in the equity market, according to Patrick Whalen, head of buyside trading at AllianceBernstein. Whalen, a former Lehman trader, got his start in equities and now focuses on an array of asset classes. The growth of high-speed trading in the equity markets in the U.S. was driven by the Securities and Exchange Commission, which wanted to make sure that individual investors received the best execution for their orders. In the swaps market, the move to electronic trading is the result of regulations adopted after the financial crisis. The point is to control systemic risk.
While regulators in many countries are mandating public clearing of swaps, in the U.S. the Commodity Futures Trading Commission wants to go one step further and demand electronic execution of swaps as well. The swaps market is still conducted mostly over the phone. Dealers conduct calls with a limited number of potential buyers — a handful, if that. And it remains an extremely lucrative business. Electronic trading could reduce transaction costs in the swaps market to $35 billion a year from $50 billion now, according to some estimates.
In the fixed-income markets, government policy is encouraging electronic trading. The transformation may not happen as quickly as it did in the equity market, but it is under way. The Volcker Rule, which will force commercial banks out of the business of proprietary trading, will prevent banks from keeping assets on their books, reducing returns and compelling them to sell fixed-income assets quickly and efficiently. Under those circumstances, electronic trading becomes a necessity. “Banks can no longer warehouse risk. They need to move it as quickly as possible,” Whalen says. “The price of liquidity is changing. Things that are illiquid are becoming more expensive to hold,” Whalen says, noting that so-called on-the-run (or most recently issued) Treasuries are cheaper than off-the-run Treasuries.
As interest rates rise, there may be less corporate debt on the market, pushing a drive for cheaper and more efficient trading via electronic venues. “Corporations may not issue new debt every two or three months,” Whalen says. As a result, there may be fewer instruments, written to common standards and traded in more liquid, electronic markets.
The shift to electronic trading will usher in changes in liquidity patterns. For example, electronic trading “is not great for moving large pieces of inventory,” Whalen says. In a market where prices are publicly displayed, institutions cannot offer a large block for sale all at once without pushing down the prices of the asset they are trying to sell. “You have to bleed it out into the market a little at a time without leaving a footprint,” he says. That is particularly true in markets such as equity and fixed-income, where the price of securities is driven by the fundamentals of the company that issued them. It is less true in markets such as currencies and commodities. While the price of 100 different stocks will vary wildly, a Swiss franc is a Swiss franc regardless of who owns it.
Meanwhile, the spread of high frequency trading in the equity market is expanding beyond the United States. “The U.S. options and equity markets are well along, and high frequency trading is also well developed in Europe. Now firms in Asia are starting to reengineer their infrastructure to reduce latency in the trading process,” says Larry Tabb, founder and CEO of financial market researcher the TABB Group.
Are electronic venues— and the high frequency strategies that inevitably take advantage of them — a good thing for the markets? After the Flash Crash of May 6, 2010, high frequency trading was cited as a source of systemic risk, and an SEC report pointed the blame at the fragmented and fragile nature of the markets. High frequency trading firms contributed to the problems that day by filling a $4.1 billion mutual fund sell order for S&P 500 E-mini contracts.
However, Moallemi says that a longer view suggests that high frequency trading may have made the equity market more resilient. After the failure of Lehman Brothers in 2008, bond markets froze up. “But you could always trade equities,” Moallemi said. “In the grand scheme of things, central clearing and trading makes markets more robust,” he says.
Not everyone is so enthusiastic about the move to electronic trading though, especially in the swaps market.
“Equity or futures contracts trade in many thousands of units a day, and are highly suitable for electronic execution and clearing. But the bulk of CDSs trade less than 10 times a day,” J. Christopher Giancarlo, executive vice president of GFI Group, told Institutional Investor in December. “Some trade only once a day. In that event, requiring electronic execution is not suitable. Less-liquid instruments require a lot of human intermediation and negotiation. A market maker is not going to let competing market makers see its position on a screen in instruments with so few bids, so little liquidity. In that case, there will be no liquidity,” he warns.
Moallemi says some swaps may be unsuitable for electronic trading, but that the he sees no reason why many products such as 10-year interest rate swaps cannot be standardized, cleared and executed via an electronic market. Interest rate swaps, which he says are probably the largest component of the derivatives market, are still largely conducted over the phone.
The CDS market, which is associated with a relatively high level of systemic risk, could “probably” make the move to electronic trading, although Moallemi says it will not be as easy to impose standards, and there are more “issues” associated with electronic trading of CDSs than there are with electronic trading of interest rate swaps.
Electronic trading is common in the foreign exchange market, but not on a centralized basis. “My understanding is there are a handful of dominant players and not everyone gets treated equally,” Moallemi says.
He concedes that there will be some bespoke contracts that always will be traded by phone between a handful of parties. But by and large, Moallemi says the resistance to electronic trading is economic and reflects the anxiety over publicly displayed prices, high frequency traders and the disruption that will follow.
