Hedge fund slump and regulation could hit US prop shops

While US high-frequency traders enjoyed a bumper year in 2008 and now account for the majority of average daily trading volume in the US, declining hedge funds volumes and regulatory change could threaten future performance, according to Sang Lee, co-founder of research consultancy Aite Group.
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While US high-frequency traders enjoyed a bumper year in 2008 and now account for the majority of average daily trading volume in the US, declining hedge funds volumes and regulatory change could threaten future performance, according to Sang Lee, co-founder of research consultancy Aite Group.

A new report from Aite, ‘New world order: the high frequency trading community and its impact on market structure’, found that high-frequency traders accounted for more that 60% of average daily trading volume in the US in 2008 and estimates this will rise to around 70% in 2009. It defined high-frequency traders as: market makers relying on automated trading technology; low-latency agency brokers; statistical arbitrage hedge funds; and high-frequency proprietary trading firms – so called ‘prop shops’.

Prop shops in particular thrived amid the market turmoil of 2008. “All of the prop shops did incredibly well last year, but the hedge fund side has taken a hit and it will be interesting to see what impact that has on the overall market,” Lee told theTRADEnews.com. “Maintaining a certain level of volume in the market is going to be very important. If that volume goes away, it will not be an ideal situation for some of these high-frequency trading firms.”

A further threat to high-frequency traders could be new US regulation designed to restore financial and economic stability. “One danger is that some of these regulations will be too sweeping, generalising every firm in the non-traditional asset management or broker/dealer area as a potential threat to the future stability of global financial services industry,” the Aite report said.

One example of potentially damaging new rules being considered is HR 1068, a bill introduced to the US House of Representatives by Peter DeFazio, which aims to levy a tax on certain securities transactions to recoup the cost of the US’s financial rescue plan. “If something like that comes through, it would not be good for the overall market in terms of people trying to generate volume,” said Lee.

Despite these potential setbacks, Lee thinks high-frequency traders have a bright future. “There aren’t that many firms out there that are capable of doing this,” he said. “High-frequency traders have made their investment in the technology infrastructure already and created very sophisticated models to participate in a market that is built for them to thrive in.”

The report estimates that there are between 10 and 15 proprietary trading houses at most with significant trading operations.

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