The hubbub over high frequency trading (HFT) has implications for investment research. The future direction of HFT will have direct implications for research. And the Michael Lewis phenomenon is a cautionary tale for the research industry.
Low carb trading
It is estimated that HFT accounts for about half of trading in the US (down from two-thirds). From the perspective of research, HFT is low-carb trading. In other words, it doesn’t pay the research bills because it is too low margin and HFT firms don’t use Wall Street research.
From the HFT perspective, research is one of the obstacles to HFT growth. In Michael Lewis’s controversial new book, the founder of IEX, a new exchange designed to counteract the evils of HFT, was challenged by buy-side inertia in directing trades because of the need to pay for research. According to Lewis, the buy-side traders were outraged by HFT predatory tactics, yet continued to send orders to the HFT-infested dark pools operated by Wall Street banks like lambs to the slaughter. All because of bank research.
The rise of high frequency research
What Lewis does not mention is that HFT has declined from its heyday, when it accounted for two-thirds of US market trading. In 2009, high-frequency traders moved about 3.25 billion shares a day. In 2012, it was 1.6 billion a day, according to a Bloomberg BusinessWeek article. It has declined because margins have declined from fierce competition among HFT firms. Average profits have fallen from about a tenth of a penny per share to a twentieth of a penny.
Lewis misses the fundamental point with HFT: it is simply automated trading. Yes, HFT trading has predatory practices, but that is not the core. The core is computerized trading. An unnerving aspect of HFT given surprisingly short shrift by Lewis is the frequency of flash crashes, which occur regularly but so quickly that humans can’t detect them. Check out his excellent TED talk on HFT: http://youtu.be/V43a-KxLFcg
For researchers, it is worth noting the current direction of HFT: high frequency research (HFR). HFTs are using sophisticated programs to analyze news wires and headlines to instantly interpret implications. Some are scanning Twitter feeds, as evidenced by the Hash Crash, the sudden selloff that followed the Associated Press’s hacked Twitter account reporting explosions at the White House. We can expect further developments and innovations in HFR as algorithms get more sophisticated.
Much has been written about the automation of trading and the declining role of human traders. The automation of research is yet to be written.
A cautionary tale
One last point. Flash Boys is compelling story of an outsider who uncovers HFT abuses and works to counteract them. While it makes for a great read, it stretches belief that Brad Katsuyama was the first to discover the pernicious effects of HFT.
Like many other aspects of Wall Street, HFT was yet another open secret (although perhaps not understood in the exacting detail that Brad pursues). Can you think of another generally accepted quirk that applies to research, just waiting for the next Michael Lewis tome?
HFT & Research
While the Wall Street banks have used HFT to augment cash equities revenues, that game is declining. HFT is fundamentally hostile to traditional bank research. Its trades don’t pay research bills, and ultimately HFT leads to a very different form of research that sends chills down the spine of every fundamental analyst.
Wall Street offers opportunities for talented writers to prosper by spotlighting commonly accepted idiosyncrasies in the markets. Or for talented politicians seeking greater fame. Will Soft Boys the next Lewis opus?