15th June 2013: HFT, Disruptive Innovation & Theta Arbitrage

23rd July 2009 was perhaps the day that retail investors became aware of high-frequency trading (HFT).

 

That was the day that New York Times journalist Charles Duhigg published an article on HFT and market microstructure changes. Duhigg’s article sparked a public controversy about HFT and changes to United States financial markets.

 

Then on 6th May 2010 came the Flash Crash. HFT was again the villain.

 

For the past few years HFT has inspired both pro and con books from publishers. HFT has changed how some retail investors and portfolio managers at mutual and pension funds view financial markets. Now, Matthew Philips of Bloomberg Businessweek reports that 2009-10 may have been HFT’s high-point in terms of being a profitable strategy.

 

Philips’ findings illustrate several often overlooked aspects of Clayton Christensen‘s Disruptive Innovation Theory. Scott Patterson notes in his book Dark Pools (New York: Crown Business, 2012) that HFT arose due to a combination of entrepreneurial innovation; technological advances in computer processing power; and changes to US Securities and Exchanges Commission regulations. Combined, these advances enabled HFT firms to trade differently to other dotcom era and post-dotcom firms that still used human traders or mechanical trading systems. This trading arbitrage fits Christensen’s Disruptive Innovation Theory as a deductive, explanatory framework.

 

The usually overlooked aspect of Disruptive Innovation Theory is that this entrepreneurial investment and experimentation gave HFT firms a time advantage: theta arbitrage. HFT firms were able to engage for about a decade in predatory trading against mutual and pension funds. HFT also disrupted momentum traders, trend-followers, scalping day traders, statistical arbitrage, and some volatility trading strategies. This disruption of trading strategies led Brian R. Brown to focus on algorithmic and quantitative black boxes in his book Chasing The Same Signals (Hoboken, NJ: John Wiley & Sons, 2010).

 

Paradoxically, by the time Duhigg wrote his New York Times article, HFT had begun to lose its profitability as a trading strategy. Sociologist of finance Donald MacKenzie noted that HFT both required significant capex and opex investment for low-latency, and this entry barrier increased competition fueled ‘winner-takes-all’ and ‘race to the bottom’ competitive dynamics. HFT’s ‘early adopters’ got the theta arbitrage that the late-comers did not have, in a more visible and now hypercompetitive market.  Duhigg’s New York Times article wording and the May 2010 Flash crash also sparked an SEC regulatory debate:

 

  • On the pro side were The Wall Street Journal’s Scott Patterson; author Rishi K. Narang (Inside The Black Box); and industry exponent Edgar Perez (The Speed Traders).
  • On the con side were Haim Bodek of Decimus Capital Markets (The Problem With HFT), and Sal L. Arnuk and Joseph C. Saluzzi of Themis Trading (Broken Markets) which specialises in equities investment for mutual and pension fund clients.
  • The winner from the 2009-12 debate about HFT regulation appears to be Tradeworx‘s Manoj Narang who was both pro HFT yet who also licensed his firm’s systems to the SEC for market surveillance, as a regulatory arbitrage move. The SEC now uses Tradworx’ systems as part of the Market Information Data Analytics System (MIDAS, Philips reports.

 

Philips announced that HFT firms now have new targets: CTAs, momentum traders, swing traders, and news sentiment analytics. That might explain some recent changes I have seen whilst trading the Australian equities market. Christensen’s Disruptive Innovation Theory and theta arbitrage both mean that a trading strategy will be profitable for a time before changes in market microstructure, technology platforms, and transaction and execution costs mean that it is no longer profitable.