High-frequency traders, the notorious traders made famous in Michael Lewis' "Flash Boys," are in trouble.
High-frequency traders, the Wall Streeters made famous by Michael Lewis' Flash Boys, use their technology to get to trades ahead of the competition. For years, this strategy raked in billions. But low volatility and rising operational costs have squeezed HFTs, precipitating a wave of consolidation and closures.
"HFT firms have been facing stiff headwinds due to low volatility," Richard Repetto, an analyst at Sandler O’Neill + Partners told Business Insider in an email. "Both implied and intraday volatility have been at lows making it difficult for HFTs to earn meaningful spreads."
Total revenues brought in by HFTs from equity trading have dropped over 85% from $7.2 billion in 2009 to $1.1 billion in 2016, according to data from the TABB Group. The consultancy expects revenues to slide to $900 million this year.
But many HFTs are looking forward and revamping their business models to grow despite this environment.
"We remain confident that the core results are a consequence of the terrible environment for a market-maker," Douglas Cifu, the CEO of Virtu Financial, a publicly traded HFT, said during an earnings call on August 10. "While we are not happy with the results, we are proactively managing our business to grow and to continue to earn an acceptable return in this environment."
High-frequency traders have seen revenues decline for years, but the historically low volatility of the past year has led to a breaking point.
"When markets don't move much, demand for the job high-frequency traders do is low," Dave Weisberger, the head of equities at ViableMkts, a market structure technology company, said. "It's simple supply and demand."
As liquidity providers, HFTs are scanning the markets for opportunities in which buyers and sellers aren't matched up. But when volatility is too low, like it has been for the past four months, those opportunities are hard to come by because there are fewer price swings.
Similarly, high volatility is undesirable as well. In a sense, HFT is kind of like surfing. A surfer wants to hit the waves during high-tide — not during low-tide or a monsoon.
Here's Michael Antonelli, an institutional equity sales trader and managing director at Robert W. Baird & Co, a Milwaukee-based firm (emphasis is our own):
It's an unusual year because there's barely been any major market moving events. Just headlines. No major macro hiccups. No Ebola scare. Generally, you are seeing a global upturn in macro data. If you go across the world, you have a lot of stock markets doing really well. They are really strong. You turn on the Bloomberg and almost everything is green.
Volatility is cyclical and so this calm environment will not persist indefinitely. But even if volatility returns to normal levels, the industry won't see the revenues it did three or four years ago, according to Larry Tabb, founder and chairman of TABB Group.
"We could probably get to $1 billion or $1.5 billion," Tabb told Business Insider."But not $2 billion or $3 billion."
Low volatility is just one issue facing HFTs, according to Don Ross, CEO of PDQ Enterprises, the parent company of CODA Markets equity trading platform.
"Low volatility is compounding an issue high-frequency traders have been facing for years: rising exchange costs," Ross told Business Insider.
HFTs pay exchanges such as Nasdaq and the NYSE to store their servers in the same building as the matching engines. But the price of this service, referred to as colocation, has become more expensive as exchanges continue to roll out more levels of service, according to Weisberger.
"It started with one gig connection to the matching engine, then they offered 10 gig connection, then 40 gig connection," he said.
"[High-frequency traders] don’t necessarily want more," Weisberger said. "They just don’t want to be one-upped by the competition."
This spike in costs has angered a lot of folks in the industry, according to reporting by Business Insider's Matt Turner. "[High costs are] the new normal," Tabb said.
HFTs can't rely on speed any longer. In order to adapt to the new environment, they'll have to shift the focus of their technology, according to Gaurav Chakravorty, the CEO of qplum, from speed to making predictions. Chakravorty previously worked at Tower Research, one of the premier HFTs, and his firm recently released a report on innovation in trading. He said high-frequency trading firms are "picking up pennies in front of a bulldozer."
"HFTs should reduce the single minded focus on latency," Chakravorty said."And they should look for profit opportunities using deep learning technology."
Deep learning tech allows computers to learn things without being programmed to do so. According to Chakravorty, HFTs can use deep learning tech to identify signals, such as when someone cancels an order, that can lead to money-making opportunities. Chakravorty said HFTs are good at developing technology so making the shift wouldn't be difficult. But it will cost money, according to Goldman Sachs.
"Further, technological advances in the space will require continued investments to stay competitive," the bank said.
Mark Smith, the CEO of Symbiont, a blockchain technology company, told Business Insider he knows of HFTs that are looking to use their technology to tap into profit opportunities in the private markets.
"There are two HFTs I've talked to who are looking for undervalued assets in the private market," Smith said. "With fewer companies going public there are more opportunities there."
HFTs are also looking to expand their technological offerings. Virtu Financial, for instance, notably partnered with JPMorgan to provide the bank with technology to enhance its electronic trading operations. Sun Trading, a Chicago-based high-frequency trading firm, provides another example. It announced a technology partnership on August 20 with Instinet, a division of Japanese bank Nomura, to help it prepare for changes to European regulations.
Joe Ciolli contributed reporting.