Winning Isn’t Just About Being Faster, It’s About Being Better

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Quant and prop traders share perspectives with Weng Cheah, Managing Director of Xinfin, about the evolution of high frequency trading.
It is unsurprising that we feel swamped by our rapidly changing industry. However, to bring some experience to these words, I had a number of conversations with quantitative and proprietary trading professionals who are responsible for managing money for themselves, or in a fund. Whilst it is not appropriate to name these individuals, the following reflects some of their perspectives.
Trading has changed dramatically in the last 25 years; firstly in that we are no longer physically present in the pit. One US-based hedge fund manager I spoke to went so far as to say that the industry had “never seen so much change in one person’s lifetime.”
This ‘electronification’ of the markets was the necessary catalyst to what has been a continuous evolution in trading, where technology has been a constant companion. However tempting it is to assume, one thing is certain, where we are today did not start by someone saying “I need to be microsecond quick to win.”
Information Process
The investment process tries to manage uncertainty by seeking information that can be sorted into a model through which we can understand the value of an asset. Information is at the heart of all investment, what is curious is that all investors do not select the same information.
There are those who will research the company and build fundamental models from the financial statements and returns as their basis for trading, and a tactical allocation model based on how macroeconomic trends could set their trade quantum.
However, there are also traders who would look at asset price history and examine price actions to set their strategy. As one US-based fund manager said “the price of corn knows more about corn than I do” reinforcing the idea that price is the source of all information.
Quantitatively they recognise that they can increase their absolute return without taking on any additional risk, by stepping up the frequency of trading. Although transaction costs are higher, this is more easily managed than market risk.

 
Goodbye Trading Pit – Hello Computer
No matter how the participant selected their trades, all of these trades were matched in trading pits. However, from the mid 1980s, trading pits around the world began to close in favour of electronic trading systems that claimed to be cheaper and more efficient for the investors.
The traders themselves did not necessarily want the change, as one Asia-based prop trader stated, more technology was the “doomsday” scenario for traders; they loved the floor and wanted to stay there. However, as highlighted by one European hedge fund manager, if one were to look at the data correlating the advent of faster electronic trading versus returns, there would be a positive correlation.
In the same way as hand signals improved the speed of communication, the electronic market was just another means of communication, and of benefit to all investors. But, no one imagined that the by-product of the matching engine, the audit trail of prices, would play such an influential role in the development of modern markets.
Technical analysis has been in use since the 1920s, and together with this new source of high quality data, it made sense to apply computing power to these calculations. This data was reliably and quickly available on every tick of the market; in short the trading engine was born.
In the brave new world of electronic exchanges, each exchange believed that in differentiation, not uniformity, lay the path of progress. Acting on this produced proprietary exchange interfaces. Differences extended all the way to regulations that treated securities and derivatives differently, and of particular importance were the rules that governed certification to the exchange interface.
In the equity world it was initially the exchange and some independent software vendors that were granted access to the exchange interface. Brokers developed their own internal order management and routing capabilities. The brokers provided services to clients, and the execution services eventually morphed the order routing technology to auto-accept orders, and then into direct market access and broker algorithms.
While there are similarities in derivative exchanges, there are some significant structural differences. Derivative contracts are uniform, and may be given up to a clearing broker. Many participants chose to be a non-clearing member, but retained the right to connect into the exchange interface.
Exchange connectivity was an ordinary infrastructure decision to many. However, to the trading firms that were experimenting with trading engines, decisions as to ‘how much’, and ‘on what’ to invest for their exchange connectivity infrastructure was strategic.
 
Evolutions in APIs, and messaging languages such as the FIX Protocol, have also meant that the speed and accuracy of communication have greatly increased. As a Londonbased hedge fund manager said “FIX was like the glass wall in the restaurant, it allowed you to see when the chef dropped the steak.”
As such all of the elements were in place to allow for the rapid development of automated trading, all that was needed was an environment to breed the change.

 
The Many Arms Races
Competition in terms of an arms race was prevalent in the exchange business, with mergers and acquisitions making headlines, and competitors evolving from ECNs, and crossing networks. Underlying the milestone transactions was intense competition for trading flow, which was waged through pricing schedules and rule changes.
Funds competed for assets to manage, and brokers to provide their products. They grew distribution to attract clients to their primary business, and invested in execution as a means of monetising the flow. Research and execution were tightly coupled, at least until the end of 2002.
Unbundling research from execution came to the world in a neatly packaged consultation paper CP154, “Best Execution”, which many believe contributed significantly to the demand for electronic equity execution products. Brokers invested into their execution capabilities, including expanding vertically into the exchange functionality with dark pools.
Trading firms then benefited from exchange competition and rising volumes. Their early experiments with trading engines had become mainstream, and significant progress had been made into research capabilities and the performance of their strategies. Some also had built out their low latency environments, including market data, execution, and co-location. Trading firms were now very visible through the volume that they were trading. Their volumes were attractive to brokers, and many invested in faster market access to attract these firms.
Therefore the changes in environment and the changes in technology became coupled, which led to the rapid evolution into high frequency trading for many exchanges.
All in the Rules
The world from 2007 onwards has seen a marked de-leveraging and consequently a decline in transaction volumes in many markets. Proportionately, automated trading made up more than half the volume of exchanges, attracting examination from the wider public.

 
Although automated trading includes fund managers using broker algorithms, as well as trading firms with their quantitative and higher frequency trades, the events of the day focused the debate on speed; specifically who has it and is it a level playing field?
May 6, 2010 will always be remembered as the Flash Crash. The speed at which the price decline occurred was surprising, hence the initial belief that it had to be caused by HFT strategies. This was such a significant event that both the SEC and CFTC were involved in the investigation. The joint report highlighted a fragmented and fragile market where “a single large trade could send stocks into a sudden spiral.” Prices stopped falling “at 2:45:28pm, trading on the e-Mini was paused for five seconds when the CME stop logic functionality was triggered.” Rules have since changed to ensure synchronisation of circuit breakers in a multi-liquidity environment.
The public will debate anomalies, albeit unintended, that come from interaction with the market. They will have a fair expectation that all participants have equal access to the market, and that the market will have rules that are up-to-date with the emerging products and technology.
One thing is for sure, as one Asiabased prop trader stated, there is now a “much healthier level of introspection” and the industry is swinging around in a full circle; what was once old is new again.
What Comes Next?
Even the briefest review of events must conclude that competition will continue evolving the markets and its participants. There has been more than a decade of significant investment; it does make you wonder what will be the next real innovation. How this will shape the business of brokerage, and the exchanges and investment managers, is something that requires much further examination.
One Asian prop trader thinks that there will be “consolidation amongst exchanges, regulatory cohesion, and HFT firms will consolidate; all this is pulling back,” while one US trader simply said “ten years ago I could see the world moving to where it is now, but I cannot see what comes next.”
Exactly what the future looks like is an issue that we will continue in the follow up to this piece, but one thing is for sure, winning isn’t just about being faster.
Go to www.fixglobal.com/content/be-careful-what-you-wish to read Weng’s thoughts on what comes next in high frequency trading, the role of brokers, and the wider future of the industry.