By Max Nussbaumer, Alpha Trading Labs LLC
Fintech is commonly associated with innovations that make consumer or business facing processes more efficient and create new products for the benefit of clients in the financial service industry. Social lending holds the promise of cutting out intermediaries and making lending more affordable and available to the public. Blockchain innovations in finance are predicted to eliminate multiple reconciliation steps in clearing processes, thereby making them more reliable and more efficient.
High frequency trading (HFT) or ‘low latency trading’ evoke a picture of a zero-sum game with highly asymmetric odds for a secretive group of quantitatively gifted. So is it even Fintech and are there any connections to the Fintech industry?
Most people got introduced to HFT by Michael Lewis’ book ‘Flash Boys’ (2015). The book creates an easy to understand narrative of the race for speed and how HFT firms gained an ‘unfair’ advantage in the market. Proof is derived from the fact that HFT firms generate consistent riskless profits. In a zero-sum world, those profits have to come at the expense of someone else, e.g. the consumer who is trying to invest for his pension.
To be fair to HFT, the book was published at a time when HFT profits had already gone into decline for a few years. Profits in the US HFT world have declined from a peak of ~7bn USD to around 1bn USD by 2017 (WSJ). Infrastructure and data collection cost have increased, competition has eroded the potential of simple ‘speed race’ strategies and a persistent decline in volatility has reduced price spreads.
While it is impossible to determine any cost from HFT to retail investors, some important factors are at work:
- HFT trading plays an important role in market making and has reduced the visible trading cost to the retail investor
- HFT accounts for a large percentage of daily trading (>50% by some accounts) and contributes large amounts of liquidity to the market.
- HFT is typically capturing a point of the third decimal per trade. While this can be regarded as a trading cost to the investor, it doesn’t matter to the average investor and trading was never entirely free. It can be regarded as compensation for a service, although not in the traditional sense of an outright agreement between two parties
A bigger issue exists for the not so fast institutional firms who get ‘picked off’ by HFT. An institution’s trade for 50M USD can bring a profit of 50K USD to the nimble HFT firm. This is both an annoyance to the institution and a cost that potentially reduces their retail client’ returns, although not that much in the long run.
Viewed from a more positive angle, HFT’s benefits to the wider community come from its contribution to technical innovations and that’s where Fintech and HFT overlap. Both feed into and profit from advances in data science, machine learning, artificial intelligence and high-performance computing.
We like to compare HFT to F1 car racing. F1 seems like a waste of money, a combination of noise and environmental pollution and people used to die in races. On the other hand, major innovations in safety, materials, engine technology and efficiency were created by that industry. We all profit from the innovations that get created on the edges of the high-speed world, both in financial services as in automobiles.