If the securities market were a dysfunctional family, high-frequency trading would be its evil genius’ cousin.
Company valuations are giving way to computational probabilities. The scope of investing in corporate stocks- from possessing research savvy to having investment skills – is being reduced to statistical un-biases, void of basing any decision on human emotion and God-given intuition. Investment gurus are being replaced by mathematical wizards.
These are the sentiments of those whom oppose the trading mechanism and it is not hard to see why this is so. Media’s portrayal of the world of high frequency trading — with words like “secretive” and “shadowy”– leaves it to be shrouded in mystery but because of the unknown factors involved it therefore becomes controversial.
Since the phenomenon of high-frequency trading (HFT) began to take off a few years ago only a handful of financial firms were involved in the practice at the time. Today these same firms account for 70% of all the trading volume done in the US marketplace. The once iconic imagery of brokers trading on Wall Street is being substituted for super-computer hubs capable of exchanging deals in nanoseconds.
Leading the charge in speed trading is IntercontinentalExchange, Inc. (NYSE: ICE), operator of electronic futures, clearing houses and the OTC marketplace. ICE trades on energy, soft agricultural commodities, currency, and other financial products on a global scale.
The latest announcement of their 2011 fourth quarter and full year financial results reported record sales for ICE. Below is an excerpt of the press release:
For the year ended December 31, 2011, consolidated revenues increased 15% to $1.33 billion. Consolidated transaction and clearing fee revenues totaled $1.18 billion in 2011, up 15% year-over-year. Transaction and clearing fee revenues in ICE’s futures segment grew 20% to $604 million. Futures volume and ADV for the year grew 16% to 381 million contracts and 1.5 million contracts, respectively. ICE Futures Europe established its fourteenth consecutive annual volume record. ICE Futures Canada also established a new volume record, and volume at ICE Futures U.S. was flat.
Global OTC segment transaction and clearing fee revenues were $572 million in 2011, an increase of 10% from 2010. ADC in ICE’s OTC energy business was a record $1.6 million, up 15% from 2010. Revenues from ICE’s CDS execution and clearing businesses totaled $167 million, comprised of $100 million from Creditex and $67 million from global CDS clearing. Through February 3, 2012, ICE’s CDS clearing houses have cleared $27.3 trillion in gross notional value, including nearly $12 trillion cleared during 2011.
The Company also reported that the benchmark for ICE Brent Crude futures contract (on the London exchange) reached a new record with open interest level of 1,001, 286 contacts on January 26, 2012.
ICE currently trades at around $133/share with a market cap of $9.65B. 2011 ROA equity amounted to 17.28% and a net profit margin of 39.30%. Cash received from operating activities for 2011 was $712.77M with $822.95M total cash and $887.70M in total debt making the company one of the top mid-cap diversified investment stocks on the NYSE, according to Benzinga.
Arguments for and against HFT reached US regulatory heights when the practice came to the forefront when in May 2010 the Dow Jones plummeted 600 points in 20 minutes resulting in a “flash crash”. Rogue algorithms are being blamed for the May 6 event and other subsequent mini crashes occurring when large transactions were made then followed by multiple cancellation orders (in attempts to exploit pricing differentials) in a short period of time creating glitch’s to the electronic market system; circuit breakers have since been installed in all US equity markets.
The Securities Industry and Financial Markets Association (SIFMA) addressed the issue in a report late 2011. SIFMA highlighted concerns over what they felt are some of the implications and changes that arose as a result of high frequency trading:
- Less Quoted Size. The smaller quotation increment brought by decimalization (1/8th of a dollar to a penny or $0.125 to $0.01) has dramatically reduced spreads and thus transaction costs for retail investors.
- Fragmentation. The ability to trade in a particular security on more than one trading venue encourages innovative marketplaces and reduces the costs of trading in these markets.
- Increased intraday market volatility. Immediate news sources and market participants’ capacity to respond more quickly to news contribute to the markets moving more swiftly now than in the past. It is unclear whether recent increased market volatility therefore should be accepted as the new norm or is aberrational.
- Separate data feeds. Exchanges and other market participants may individually disseminate their own data feeds and often charge more for access to feeds with additional data elements and for data that are delivered more quickly (that is, with lower latency).
- Inaccurate market data (e.g., slow market data feeds, crossed markets, erroneous prints). Inaccurate or unreliable market data has significant consequences for market participants as the speed of trading increases.
- Changes in market making and use of new order types. The former liquidity provision model of specialists and market makers with central positions in the trading process has shifted to a more electronic form of market making with the ever more sophisticated use of specialized liquidity providing order types.
- Impacts during periods of market duress. The combination of fully electronic markets and computer-based trading, coupled with the stress on our market data and connectivity infrastructure, creates the possibility of rapid, extreme moves during times of duress in the markets.
While the HFT debate rolls on, Bank of America’s stock capitalizes. Speed traders have latched on to the S&P 500 giant. As reported by CBSNews, “The bank’s single-digit stock price and flood of shares on the market — three times as many as its nearest big-bank competitor at 10.5 billion shares outstanding — make it an attractive target for hedge funds and banks that employ high-powered, computerized trading.” The article went on to state:
“For computers to move in and out quickly, there must be enough shares available to trade. Bank of America has a truckload — 10.5 billion shares outstanding, compared with 3.8 billion for JPMorgan Chase and 2.9 billion for Citigroup. The stock traded as high as $15.31 last year. Then investors, worried about how deep the bank’s mortgage problems might be, drove it below $10 in July. High-frequency traders pounced, and Bank of America’s volume exploded. It was 147 million shares last summer. On Thursday [February 8], 477 million shares changed hands. The low price put it in the sweet spot for high-frequency trading. If a high-frequency operation is trading blocks of 100 shares at a time to capitalize on a 1-cent change, there’s a lot less risk working with a $5 stock than a $500 one.”
In one year (February 14, 2011 to February 13, 2012) Bank of America (NYSE: BAC) went from a stock price of $14.89 to $8.07, a -45.80% drop to presently having a YTD stock increase of 29.83% ($5.81-$8.28).
Speed traders have shifted more of their focus onto commodities and currency markets and the Commodity Futures Trading Commission (CCFTC) is setting up a subcommittee just to handle HFTs in an effort to get “a clearer understanding of how electronic trading affects commodities markets and participants,” as stated by WSJ.
No worries though for ICE and its competitors as they are expanding the trading volume on several global levels including the BRIC (Brazil, Russia, India and China) nations. As also reported by the WSJ, “ICE anticipates more overseas companies looking to hedge the risk of price swings in energy markets and an influx of new business as governments direct private derivatives transactions toward regulated, electronic platforms, such as those run by the Atlanta-based company.” And Bloomberg notes that Marex, the financial commodities broker, believes high frequency trading in metals could account for 20 percent of volume on the London Metal Exchange in just a few years.
Market momentum, liquidity and volatility are key components to any trading/investing strategy.
The difference, however, for high frequency traders is the manner in which these same components are factored into the financial – figurative and literal- equation. High volume, varied price movements and low volatility are contributors to its trading success. The equation in question is called algorithms, mathematical computations used in creating complex computer codes, which is comprised from the data of past financial “tapes” — industry jargon for the record of the day’s transactions.
If you’re an investor or trader knowledge is king, but, will speed soon trump information, insight and ingenuity all together? Only time and know-how (whether by ‘brain’ muscle or machinery) will tell.