The extreme market dislocations caused by the financial crisis of 2008 have given way to record-low levels of volatility. Not coincidentally, high-frequency trading (HFT) profitability and revenue have declined dramatically. High-frequency trading revenue reached $7.2 billion at its peak in 2009 before declining to $1.8 billion in 2012, according to the Tabb Group. The VIX (the S&P 500 implied volatility index) peaked in 2008 and has declined to an all-time low of a little over 10 (Figure 1). The CBOE crude oil implied volatility index has likewise declined dramatically since 2008 (Figure 2), and in fact reached its lowest level since 1996.
The crushing of profits against the backdrop of massive technology investment has decimated HFT returns, and many firms have downsized or exited the business.
This year might see an uptick in HFT profits. Adam Sussman of The Tabb group predicts “revenue from high-frequency stock trading may increase by about 22 percent to $2.2 billion in 2013 as volume in U.S. equity markets rebounds following a three-year slump.” (Bloomberg data indicate that daily average volume in 2012 was about 6.4 billion shares, vs. nearly 9.8 billion in 2009.)
HFT is at a cyclical low, not a secular one. Volatility will at some point revert to and exceed the mean, and more turbulence in the markets will return. We just don’t know when. But when it does, HFT profitability will likely explode, more investment in speed and complexity will ensue, and the danger HFT poses to market stability will increase.
Not that the industry hasn’t continued its quest for more speed even while returns plummet. A recent addition to the arsenal of weapons is something called Field-Programmable Gate Arrays (FPGAs). FPGAs are hardware-programmable silicon chips. In contrast to processors that you find in your PC, programming an FPGA “rewires” the chip itself by allowing the user to program logic gates and allocate random-access memory blocks to implement functionality. The significance for HFT is the ability to run algorithms at “wire speed”.
A recent study authored in part by Andrei Kirilenko, Chief Economict of the Commodities Futures Trading Commission, concluded “the profits of HFTs are mainly derived from opportunistic traders, but also from fundamental (institutional) traders, small (retail) traders, and non-HFT market makers… We show that the level of profits is significantly higher for liquidity-taking HFTs than for liquidity-providing ones: the average Aggressive HFTs earned $45,267 in gross trading profits in August 2010, while Mixed and Passive HFTs earned significantly less: only $19,466 and $2,461 per day, respectively… The fact that Aggressive HFTs earn substantially higher profits than Passive HFTs suggests there is a strong profit motive for liquidity taking rather than liquidity providing.”
HFT has been lauded for injecting new liquidity into the marketplace. The conclusion above challenges that notion. Indeed, the May 2010 Flash Crash was in part exacerbated by the sudden and utter disappearance of an HFT bid for E-Mini S&P 500 futures contracts, moments after they rapidly accumulating same.
Recently, Commodities Futures Trading Commission member Bart Chilton said the following, regarding whether HFTs inject liquidity: “In voluminous instances these cheetahs are engaged in this activity [wash sales – when a party buys a contract from itself]…when they do so, it might appear to be liquidity, but it is not. It isn’t really there. It’s fantasy liquidity.”
As HFT gets ever faster, and liquidity concerns seem to multiple, it seems even more obviously dangerous, and actually detrimental (even absent an HFT-induced market meltdown), to human investors and traders. I believe it is not a stretch to assert that HFT is a threat to one of the most important components of the capitalist system – the stock market. The market’s most critical role is to efficiently allocate capital by allowing the investing public to evaluate investment opportunities and commit capital to the most promising ones. HFT has absolutely nothing to do with that. And yet it comprises over half of all equity trading.
Some lawmakers are targeting HFT. Massachusetts Democrat Ed Markey, who recently wrote a letter to the SEC, bluntly urging a curb to HFT activities. Markey state that “Given the evidence that HFT has already caused unnecessary volatility in our stock markets and could reasonably be expected to contribute to increased volatility in the future, I urge the Commission…to consider using its authority to adopt rules…that limit the use of HFT technology.”
The SEC is ramping up its HFT surveillance efforts significantly, very late in the game (and the FBI recently announced it would be working with the SEC to identify and prosecute HFT abuse). It has requested 1,355 Enforcement personnel in fiscal (September) 2013, up from an estimated 1,247 in fiscal 2012 (will 107 more people make a difference?). Likewise, the SEC has requested a respective 990 versus 866 in Compliance Inspections and Examinations personnel. Finally, the SEC has requested an increase in spending on equipment to $81.9m in fiscal 2013 from an estimated $71.1m in fiscal 2012. Excellent. But puny, and laughably dwarfed by the estimated $2 billion, +/- depending on where we are in the cycle, spent annually by the HFT industry. Not to overstate, but $81.9 million is, um, 4% of $2b. The SEC is the little engine that can’t.
Not long ago I published an article entitled, “High-Frequency Trading: A Grave Threat to the Markets and the Economy. In that article, I outlined a worst-case scenario in which high-frequency trading errors (or simply unpredictable interactions) result in a global market meltdown, with public confidence in the markets shattered, investment capital for growth made virtually unavailable, and major deposit-taking institutions destabilized. The Volcker Rule, which would force deposit-taking institutions to exit the proprietary trading business, is still not implemented.
I supported my thesis in part by emphasizing systemic lack of adequate testing. This comment, from Dr. Nancy Leveson of MIT, is worth repeating: “I don’t want to sound like Chicken Little or a latter day Luddite. I did not get a Ph.D. in computer science and spend 47 years working in the field just to try and convince everyone not to use computers. But the bottom line is that there’s 100 percent certainty that you will have more upsets caused by the financial system software and probably in not too long a time, but it will occur, and it’s probably going to start occurring unless something is done more frequently because people are going to keep adding more functionality and more risk into the system unless it’s limited…all software contains errors. I have not in all of that time ever come across any software that was not trivial in which no errors were found during operations. The errors may not surface for a long time, but they’re lurking there and waiting until just the right conditions occur” (emphasis added).
 The Trading Profits of High Frequency Traders. Matthew Baron, Jonathan Brogaard and Andrei Kirilenko. Draft, November 2012.
 Comments made by Chilton in a speech prepared for the National Grain & Feed Association conference in San Francisco, March 17 2013 (Bloomberg).
 According to a February 27 article in the Wall Street Journal quoting sources “close to the talks”, the five regulators working on the Volcker rule, which would restrict banks from making speculative investments, may not come to agreement until the second half of 2013, in yet another delay (its official implementation was set for July 2012). So depositors remain at risk.
 SEC-hosted conference, “Roundtable on Technology and Investing: Promoting Stability in Today’s Markets.” October 2012.