Secrecy, Strategy, and Speed are the terms that best define high-frequency trading (HFT) firms and indeed, the financial industry at large as it exists today.
HFT firms are secretive about their ways of operating and keys to success. The important people associated with HFT have shunned the limelight and preferred to be lesser-known, though that's changing now.
What Are High-Frequency Trading (HFT) Firms?
The firms in the HFT business operate through multiple strategies to trade and make money. The strategies include different forms of arbitrage—index arbitrage, volatility arbitrage, statistical arbitrage, and merger arbitrage along with global macro, long/short equity, passive market making, and so on.
Let’s explore some more about the types of HFT firms, their strategies to make money, major players, and more.
How High-Frequency Trading (HFT) Firms Work
HFT firms generally use private money, private technology, and a number of private strategies to generate profits. High-frequency trading firms can be divided broadly into three types.
- The most common and biggest form of HFT firm is the independent proprietary firm. Proprietary trading (or "prop trading") is executed with the firm’s own money and not that of clients. LIkewise, the profits are for the firm and not for external clients.
- Some HTF firms are a subsidiary part of a broker-dealer firm. Many of the regular broker-dealer firms have a sub-section known as proprietary trading desks, where HFT is done. This section is separated from the business the firm does for its regular, external customers.
- Lastly, the HFT firms also operate as hedge funds. Their main focus is to profit from the inefficiencies in pricing across securities and other asset categories using arbitrage.
Prior to the Volcker Rule, many investment banks had segments dedicated to HFT. Post-Volcker, no commercial banks can have proprietary trading desks or any such hedge fund investments. Though all major banks have shut down their HFT shops, a few of these banks are still facing allegations about possible HFT-related malfeasance conducted in the past.
How Do They Make Money?
There are many strategies employed by the propriety traders to make money for their firms; some are quite commonplace, some are more controversial.
Trading on Buy and Sell Side
These firms trade from both sides (i.e., they place orders to buy as well as sell using limit orders that are above the current marketplace, in the case of selling, and slightly below the current market price, in the case of buying). The difference between the two is the profit they pocket.
Another source of income for HFT firms is that they get paid for providing liquidity by the Electronic Communications Networks (ECNs) and some exchanges. HFT firms play the role of market makers by creating bid-ask spreads, churning mostly low-priced, high-volume stocks (typical favorites for HFT) many times in a single day. These firms hedge the risk by squaring off the trade and creating a new one.
Another way these firms make money is by looking for price discrepancies between securities on different exchanges or asset classes. This strategy is called statistical arbitrage, wherein a proprietary trader is on the lookout for temporary inconsistencies in prices across different exchanges. With the help of ultra-fast transactions, they capitalize on these minor fluctuations which many don’t even get to notice.
Create Rapid Price Movement
HFT firms also make money by indulging in momentum ignition. The firm might aim to cause a spike in the price of a stock by using a series of trades with the motive of attracting other algorithm traders to also trade that stock. The instigator of the whole process knows that after the somewhat “artificially created” rapid price movement, the price reverts to normal, and thus the trader profits by taking a position early on and eventually trading out before it fizzles out.
The HFT world has players ranging from small firms to medium sized companies and big players. A few names from the industry (in no particular order) include:
- Chopper Trading
- DRW Holdings LLC
- Tradebot Systems Inc.
- Susquehanna International Group LLP (SIG)
- Virtu Financial
- Allston Trading LLC
- Geneva Trading
- Hudson River Trading (HRT)
- Jump Trading
- Five Rings Capital LLC
- Jane Street
The firms engaged in HFT often face risks related to software anomaly, dynamic market conditions, as well as regulations, and compliance. One of the glaring instances was a fiasco that took place on August 1, 2012, which brought Knight Capital Group close to bankruptcy. It lost $400 million in less than an hour after markets opened that day. The “trading glitch,” caused by an algorithm malfunction, led to erratic trade and bad orders across 150 different stocks. The company was eventually bailed out.
These companies have to work on their risk management since they are expected to ensure a lot of regulatory compliance as well as tackle operational and technological challenges.
The Bottom Line
The firms operating in the HFT industry have earned a bad name for themselves because of their secretive ways of doing things. However, these firms are slowly shedding this image and coming out in the open. The high frequency trading has spread in all prominent markets and is a big part of it. As of 2020, it is estimated that these firms account for around 50% of equities trading volume in the U.S. The HFT firms have many challenges ahead, as time and again their strategies have been questioned and there are many proposals which could impact their business going forward.