Gregory Meyer, Nicole Bullock and Joe Rennison in New York
The 19th century newspaper editor Horace Greeley urged young Americans to “Go West” to the unsettled frontier. When he went himself, the trip from Chicago to the Pacific took two-and-a-half months by steamboat and ox-drawn wagon. He later advocated a transcontinental railroad to speed up commerce and shorten the mail service to 10 days. Wall Street’s fastest trading firms are invoking the spirit of Greeley as they build Go West, a trail of wireless towers, fibre-optic lines and submarine cables linking Chicago, the Pacific coast and Tokyo. Transmitting market data end to end will take fractions of a second for traders seeking topreserve an edge.
Go West, which is due to be operational in early 2018, is the latest stage in a quest to movefinancial transactions closer to the speed of light. But it is also a sign of pressures inside thelucrative high-frequency trading sector. Rather than outpace each other with competing paths to Tokyo, top companies formed a consortium to build a single route, sharing bandwidth and costs. Since markets left bustling exchange floors for computer data centres a decade ago, the majority of deals in equities and futures have come to be executed by machines — automated and lightningfast. The high-frequency trading land rush unleashed frenzied investment in wireless capacity, efficient computer switches and coding talent. It also sparked complaints that the speediest preyed on investors and caused flash crashes. The rise of HFT means that ordinary investors buying or selling stocks, bonds, exchange traded funds or futures are likely to be transacting with an algorithm on the other side.
But the bonanza has now ended. Trading firms are struggling to wring profits from the incremental millisecond. Subdued volumes and reduced volatility have shrunken the size of the pie. Exchanges have ratcheted up market data and technology costs for customers. In 2017, aggregate revenues for HFT companies from trading US stocks was set to fall below $1bn for the first time since at least the financial crisis, down from $7.2bn in 2009, according to estimates from Tabb Group, a consultancy.
“The combination of low volatility and increasing costs has been tough for firms,” says RobCreamer, chief executive of Geneva Trading, a Chicago-based firm. “People see it as a war ofattrition.”
The straitened times have led to consolidation, with some firms selling out to stronger rivals. The wave could result in only a few large players that are able to invest in the best technology and a bottom tier of niche specialists, making mid-sized firms uncompetitive, industry executives say. The effects on liquidity, the ability to buy and sell without moving the price, are unknown. The survivors are searching for new ways to make or save money. Some are gambling on untested cryptocurrency markets, mainly because they offer volatility. In a sign of the times, Go West’s owners plan to rent out spare capacity to any trader who wants to use it, effectively calling a truce on speed.
“It has got to the point where the speed is so ubiquitous that there really isn’t much left to get,” says Doug Duquette of Vertex Analytics, a software company that analyses nanosecond-level futures data.
Electronic trading first emerged in parallel to exchange floors where brokers and tradersshouted out orders. Then it killed off the floors, a notable exception being at the New York Stock Exchange, now largely a promotional backdrop for companies listed there. The real action on the NYSE takes place in suburban Mahwah, New Jersey, at a data centre ringed bytelecommunications masts.
Prescient floor traders knew where markets were going and enlisted technology to help themconquer the new landscape. They founded proprietary trading firms, which bet their own capital capturing fleeting price discrepancies in markets. As Wall Street banks were forced to close their proprietary trading desks after the crisis, independent “prop shops” filled some of the gaps. Little known to the investing public, their bosses made fortunes: Vincent Viola, a former gasoline trader who founded Virtu Financial, now the biggest listed proprietary trading firm, became a billionaire.
Speed was integral. Traders paid exchanges to “co-locate” computers in cages beside matching engines, the electronic equivalent of exchange floors. This way they could be first to receive market signals and adjust their orders, beating investors outside the building.
The advent of the Regulation National Market System (NMS), a US stock market reform passed in 2005, smashed old exchange monopolies into a constellation of trading venues, creating opportunities for the nimble to find the best deals ahead of others.
Trading firms also captured price discrepancies between securities and the futures tracking them, such as the stocks in the S&P 500 equity index, traded in New Jersey, and equivalent S&P 500 futures listed on the Chicago Mercantile Exchange. Thus began a secretive race to build telecommunications networks as straight as possible across the Appalachian mountains: first fibreoptic cables and then microwave towers that transmit data in eight milliseconds.
The construction was chronicled in Flash Boys, the 2014 book by Michael Lewis that attacked HFT for exploiting a “pernicious inequality” unleashed by the NMS regulation. “A small class of insiders with the resources to create speed were now allowed to preview the market and trade on what they had seen,” he wrote. The book led to congressional hearings.
At the height of the furore, markets themselves were already turning tougher. The financial crisis of 2008 detonated furious price swings. Volatility, the amount a market moves in a given period of time and therefore essential for the high-frequency traders to make money, increased. But since then, markets have become the sleepiest in 50 years, as measured by daily price moves in the S&P 500 stock index.
Trading volumes have also been subdued: the number of shares transacted in the first half of 2017 was down 12.2 per cent year on year, while exchange-traded derivatives volumes were off 5 percent, according to the World Federation of Exchanges. The lethargy reflects the impact of monetary stimulus from central banks, which propped up asset values and held down interest rates, the popularity of passive investment vehicles such as index-tracker funds and even a flip from scarcity to plenty in the commodities markets.
Falling volume means fewer chances to trade, while low volatility allows less money to be made on each transaction. “For these businesses to make money, they need raw materials,” says Vikas Shah, an investment banker at Rosenblatt Securities. “The raw materials are volumes and volatility.” When Virtu went public in 2015 — the Flash Boys uproar having delayed its initial public offering by a year — the company’s annual revenue hit $714.5m. Last year it was expected to total just over $500m, according to S&P Capital IQ, even after it acquired fellow HFT pioneer KCG Holdings in a $1.4bn deal.
Traders are also shouldering higher fixed costs. Exchanges need high-volume traders to keep their markets liquid and provide rebates on transaction fees to trading firms willing to buy and sell all day long. In turn traders gravitate to active markets where it is easy and cheap to find buyers and sellers.
But exchanges, now for-profit companies, increasingly rely on sales of market data to generate profits as volumes stagnate, squeezing trading companies that need a fire hose of data to survive. Wolverine Trading, a Chicago-based proprietary firm, complained to regulators that its market data fees from the NYSE had increased more than 700 per cent in eight years. Plugging into exchanges such as the NYSE and Nasdaq require monthly payments of between $10,000 and $22,000 per connection, according to fee schedules.
While essential to play the game, speed is no longer enough to win it. And with volumes soft, there are only so many good trades the fastest can pounce on. “So many participants have achieved speed parity with other participants, and there’s only so much liquidity available on any given day,” says Mr Duquette. When exchanges and service companies offer faster data feeds, bandwidth and computer hardware, trading firms must consider whether to pay for it or lose out to the others that do.
An HFT boss who recently sold his company amid cost pressures says he and colleagues considered a pitch for an ultra-fast communications route between Chicago and Tokyo a few years ago. “I said our first choice is nobody builds it,” he recalls, “because everyone is going to have to pay for it. We don’t necessarily value absolute speed as much as relative speed.”Proprietary firms also now face competition from brokers and hedge funds. RenaissanceTechnologies, one of the world’s biggest quantitative hedge funds, has applied for a patent on a precision clock to execute trades on multiple exchanges all at once, aiming to head off what it called the “predatory practice” of HFT.
Then there are enterprises such as Alpha Trading Labs, a Chicago-based start-up created byindustry veterans which will share its HFT systems with any aspiring trader for a cut of the profits, with an aim “to democratise high-frequency trading,” its website says.
Mounting costs on top of declining revenues have spurred a wave of consolidation in the sector. Aside from the Virtu-KCG deal, Chicago derivatives group DRW, whose 800 employees make it a major player, has in recent years purchased Chopper Trading and RGM Advisors, while Teza Technologies, also of Chicago, has sold its HFT business to Virtu and Quantlab of Houston.
“The guys on top will still be fine because of the amount of volume that they do, the number ofstrategies they have,” says Sam Mehta, a former chief operating officer at Chicago-based SunTrading. “But these guys in the middle, with volatility at this level, they just can’t survive.”
Some firms are resorting to largely unregulated markets such as bitcoin, where prices can swing as much as 30 per cent in a day. DRW, already active in cryptocurrency and commercial real estate, has hired a team to swap physical cargoes of petroleum products on the US Gulf coast — a market where deals are normally settled in weeks.
“It’s not like it’s all bleak and there’s nothing to do,” says Don Wilson, DRW’s founder and chiefexecutive. “We see lots of interesting things to do.”
In acknowledgment that the racy industry may be settling into boring middle age, banks have begun enlisting HFT firms to execute some deals rather than spend money to upgrade their own systems. The French bank BNP Paribas recently joined with Global Trading Systems of New York to trade US Treasury bonds. Traders are also focusing on strategies that involve using other information, such as “alternative data” scraped from consumer records and social media. “Speed was a differentiator when you moved from the floor to the screen. Now it’s more about access to information, which is becoming increasingly complex,” says Lynn Martin, president of ICE Data Services, a unit of Intercontinental Exchange, which is selling capacity on Go West. Traders still hold out hope that volatility and volumes will return. Mr Wilson of DRW points to the Federal Reserve’s moves to unload mortgages acquired during the financial crisis, which could prompt massive flows of interest rate trading by fund managers. The prospect of a sharp turn for soaring stock markets could also breathe life into trading.
“Maybe we are coming to the end of automating the things that were easy to automate,” says Matt Haraburda, president of Chicago-based XR Trading. “Now the real fun starts.”Moments in speed trading
1851 — Paul Julius Reuter begins sending stock market quotations between London and Paris via a cable beneath the English Channel, having previously deployed pigeons to carry stock prices in Europe.1990s — The rise of electronic marketplaces such as Archipelago, acquired by the New York Stock Exchange, Island ECN, now a part of Nasdaq, and Globex at the Chicago Mercantile Exchange enable algorithms to read market data and automatically execute trades.2000 — Decimalisation of US stock prices allows investors to buy and sell in penny increments, cutting the price spreads that underpinned profit margins for market-makers and encouraging traders to increase volumes to make up the difference.Mid-2000s — Exchanges let traders pay to co-locate computers inside data centres, enablingthem to receive and act on market data faster than those outside.2005 — Regulation National Market System in the US increases competition among stock trading venues and turbocharges a race for the fastest technology between exchanges.2010 — Spread Networks opens a fibre-optic link between New York and Chicago, reducinground-trip latency to 13.3 milliseconds, or thousandths of a second. Speeds are soon eclipsed by microwave networks that convey market data in about 8 milliseconds.2012 — An electronic trading glitch causes Knight Capital to mistakenly purchase billions ofdollars of shares in 148 NYSE stocks, causing more than $400m in losses and forcing its sale to Virtu Financial, a rival HFT company.2018 — Go West to go live between Chicago and Tokyo, speeding the flow of futures-market data over wireless towers, fibre-optic lines and submarine cables. It is a joint venture of big trading firms such as DRW, IMC and Jump Trading.