Demystifying and Evaluating High Frequency Equities Trading: Fast Forward or Pause?

by David Easthope, December 18, 2009

Abstract

High frequency trading of equities has been a growing trend for some time, though the topic has been rediscovered of late. Enabled by regulatory change, an evolving market structure, and technological innovation in the trading arena, HFT now constitiutes about 42% of daily US equities share volume and is expected to exceed 50% by mid-2010.

Media reports and current SEC investigations have fanned the flames of a debate on high frequency trading (HFT) of equities. Market participants are concerned not only as to who and what constitute HFT, but also with evaluating important market implications of the growing trend, according to a new report, Demystifying and Evaluating High Frequency Equities Trading: Fast Forward or Pause? HFT is a means, not an end in itself, driven by the popularty of certain strategies. Thus, by making assumptions for the current and future propensity for latency-sensitive strategies to be adopted by hedge funds, proprietary trading firms, and electronic market-makers, we estimate that 42% of daily US equity share volume in 4Q09 is related to high-speed, high frequency trading and should grow to 54% by fourth quarter 2010.

"Adoption of HFT will be driven by an expansion of quantitative hedge fund strategies and the growth of proprietary trading firms," says David Easthope, senior analyst with Celent’s Capital Markets group and coauthor of the report. “The convergence of fundamental and quantitative strategies by some firms will mean the coupling of execution and investment strategies, leading to greater HFT adoption even among more traditionally conservative organizations."


"The reality of the evolved electronic environment is that the new trading rules of the game are now based on technology,” adds Chermaine Lee, analyst with Celent’s Capital Markets group and coauthor of the report. “The buy side can counteract the loss of a competitive edge by optimizing the use of execution algorithms and adjusting execution strategies more regularly."

HFT exhibits regional variations, with Asia and Latin America demonstrating signs of the adoption of higher speed, high-turnover trading in the next few years. However, more heavy-handed regulation and comparatively lagging market structure, including exchange matching systems, will be barriers to adoption of certain strategies. In this report, Celent evaluates the impact of HFT and highlights pros and cons. The report also examines liquidity provisioning from automated market-making, latency and technological competition, intraday volatility, and market impact costs.

Celent is a research and advisory firm dedicated to helping financial institutions formulate comprehensive business and technology strategies. Celent publishes reports identifying trends and best practices in financial services technology and conducts consulting engagements for financial institutions looking to use technology to enhance existing business processes or launch new business strategies. With a team of internationally based analysts, Celent is uniquely positioned to offer strategic advice and market insights on a global basis. Celent is a member of the Oliver Wyman Group, which is a wholly-owned operating unit of Marsh & McLennan Companies [NYSE: MMC].

Media Contacts

North America
Michele Pace
mpace@celent.com
Tel: +1 212 345 1366

Europe (London)
Chris Williams
cwilliams@celent.com
Tel: +44 (0)782 448 3336

Asia (Tokyo)
Yumi Nagaoka
ynagaoka@celent.com
Tel.: +81 3 3500 3023

Table of Contents

Executive Summary

3

Introduction

5

 

Everything Old Is New Again

5

 

Sorting Through the Hype

5

 

Our Approach

5

Background

7

 

Definition

7

 

What HFT Is Not

8

Equities Market Structure as an Enabler of HFT

10

 

Market Structure Drivers

11

 

Market Innovations Evolve the Structure

11

 

The Innovation Pyramid

11

 

HFT in the Local Context

13

HFT Market Sizing

17

Future Developments in HFT

20

 

US Market

20

 

HFT in Asia

21

 

HFT in Latin America

22

Evaluation of the Impact of HFT in Equities Markets

23

 

Pros

23

 

Cons

29

Conclusion

38

Leveraging Celent’s Expertise

39

 

Support for Financial Institutions

39

 

Support for Vendors

39

Related Celent Research

40

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