High-frequency trading (HFT) will continue to grow in most parts of the world despite the likely imposition of restrictions, according to a new paper from agency broker Instinet.
Regulators in many markets are concerned that the recent growth of HFT could pose new systemic risks. According to industry estimates, high-frequency strategies are thought to account for around 60% of trading in the US and up to 40% of trading in Europe. Policy makers in the UK, France and the Netherlands, for example, are conducting separate studies into HFT, while the European Commission suggested creating a regulatory category for firms that engage in HFT in its MiFID consultation paper released in December 2010.
Furthermore, the Investment Industry Regulatory Organization of Canada (IIROC), Canada's financial regulator, has proposed new tariffs that would charge trading venues per message, rather than per executed trade. If these costs are passed down by trading venues to their members, it would have a marked impact on the execution fees paid by HFTs, which typically send a large number of ”immediate or cancel' order types compared to traditional investment managers.
US regulator the Securities and Exchange Commission recently passed legislation banning the use of naked sponsored access, which allowed firms to trade directly on an exchange using a broker's infrastructure without pre-trade risk controls.
As a result of the evolving regulatory environment, Alison Crosthwait, director, global trading research, Instinet and author of ”Eleven market structure trends to watch for in 2011', predicts that smaller HFT firms will struggle to cope with the costs of new rules and could either cease to exist or be absorbed by larger players.
“Fees on messaging traffic will lead to compressed margins for HFT firms,” Crosthwait told theTRADEnews.com. “The bigger HFT firms with large compliance departments will probably be able to cope with these changes but it will be much more costly for the smaller ones.”
Crosthwait added that she would be “surprised” if other regulators across the globe did not follow Canada's lead and start charging on a per message basis. In a request for comment paper released at the end of November, IIROC stated that message-specific tariffs would help it to recover the costs associated with increased levels of market surveillance.
Despite the likelihood of further regulations this year, Crosthwait anticipates HFT to continue growing in Asia and Europe, but less so in the US.
“We have reached the point in the US where HFTs are trading with each other, so I don't think the US market can really sustain any more HFT volume,” she said. “While HFT is likely to continue growing in Asia and Europe, the new rules will put buy-side traders at ease and help to further their understanding of the practice.”
Struggling to stand out
In her paper, Crosthwait also highlights the reduction of trading volume in stocks commonly included in the most popular exchange-traded funds (ETFs), a trend that has been most prominent in the US. According to research from Instinet’s parent company Nomura published in October, the average pairwise correlation between stocks across global markets is currently 31% compared to an average of 18% over the last ten years. However, the paper notes that this level of correlation is not outside the bounds of historical precedent. While it says that an increase in ETF flow could drag all stocks towards a single benchmark, the paper found a similar increase in correlations at both the global and regional level despite different levels of ETF activity. The paper also notes that the trend towards globalisation and periods of mutual fund outflows could also be drivers for higher correlations, but did not fully explain the levels seen currently.
ETFs are instruments based on specific groups or types of stocks. As their use continues to grow, active asset managers have argued that stock picking has become more difficult because the correlations between similar stocks is too high.
“Rather than stock picking, actively managed funds are investing in different sectors and not differentiating between the stocks within them,” said Crosthwait. “The high correlations this causes between stocks means institutions are struggling for ideas and conviction, and are therefore trading less.”
While she anticipates the trend towards lower volumes to continue, Crosthwait warns against curbing the use of ETFs, noting that these instruments represent investor demand for low-cost diversification.
“There has been no catalyst for new types of investing or new ideas, and it's harder to make money and generate new ideas,” she said. “Something fundamental or economic needs to happen for this to change.”