Type of Firm
Assets Under Management
HFT as Percentage of Algorithmic Total
High frequency trading is highly competitive, so firms are often loath to reveal much about their strategies and technical architectures for fear of eroding their advantage. Only a few hundred firms are said to be serious players, although rather more are now using it as a niche overlay strategy to diversify sources of alpha. Large brokers and market makers have been forced to use high frequency strategies due to latency arbitrage, market fragmentation and the sheer aggregation of algorithmically driven flow volumes. Thus indirectly most traders now make use of high frequency strategies for a growing proportion of that flow, although they may only have a vague awareness of the details involved.
Technology advantages come and go, as new and faster routes are engineered, technology firms leap-frog each other, and new types of participants enter the market. Many of these are smaller, more agile firms as technology and outsourcing have drastically reduced the cost of entry. They have democratised the markets, as some have described it. So secret sauces and constant innovation are crucially important.
Given the hush-hush nature of the beast, evidence on the ground about high frequency trading practice is fairly thin and anecdotal. To remedy that, Automated Trader organised a global survey through their website during April and May 2010, assuring participants of full anonymity in the results and allowing them early access to survey conclusions in exchange for their participation.
The survey set out to gain a comprehensive picture of the speed and extent that algorithmic and high frequency trading is evolving amongst different types of market participant across different asset classes, together with some indications on the challenges respondents face as they seek to find and keep their edge. What emerges is a vibrant picture of a growing and confident community of traders transforming global markets, yet there's a warning as well that that speed implies risks that will need to be addressed. The survey attracted reasonably complete responses from 171 global participants from a wide range of sell and buy side firms, augmented with the input of a number of technology and market infrastructure companies.
Survey participants were self-selecting, freely responding or not to the web survey. E-mail invitations were sent to the full subscriber list of Automated Trader and to the 1,100+ people who registered for two webinars on high frequency trading that took place during the survey. Given the detailed and competitive nature of the data, participants in the survey were free to skip any questions for which they either did not know the answers or preferred not to comment. Therefore, unless otherwise stated all distributions are compared to the total number of responses to the question, rather than the whole of the relevant survey population. Any conclusions need to bear these caveats in mind, and any quantitative results must be deemed at best indicative. However, they appear remarkably consistent with the picture of high frequency trading that has been building up over recent months, and so give a fascinating new perspective on this 'high tech' market space.
Individually the participating organisations reported liquidity contributions ranging from one order per minute to over five thousand orders per second across more than 100 market centres. 45% of traders estimated their cumulative high frequency flow across all algos as less than 5 orders per second, while 18% estimated their firms contributed over 500 orders per second to the markets.
Only 40% of responses revealed their assets under management. Of these 60% claimed they were less than $100m. However, this may relate to the individual fund sizes using high frequency strategies as much as to the firm's total mandates. Of buy side firms only 32% were in this smallest category. However, nearly 6% of responses claimed to manage over $10 billion in assets. For firms providing balance sheet size, 18 participants or over 10% of total survey responses claimed balance sheets over $5bn, and most of those exceeded $500bn.
A wide range of people participated. Trading related roles dominated with over 58% describing themselves as traders, quants or other front office managers including the 10% who described themselves as owners. Next came technology and other market infrastructure roles with over 38% of responses, while the remaining 4% came from the middle or back office including risk specialists.
61% of responses described themselves as using high frequency strategies for less than a third of their overall trading activity. This probably ignores some discretionary trading that may use high frequency broker algos on the way to market. Over 27% indicated they were heavy users, with such high frequency strategies dominating two-thirds or more of their flow, while the remainder, around 12%, was in between. This is probably a good reflection of the overall market distribution given the growing interest in high frequency as an overlay strategy.
Greatest usage appeared perhaps predictably in hedge funds with heavy high frequency usage rising to 45% of firms with nearly as much for participating day traders. Meanwhile sell side firms reported using high frequency more as a niche activity. Predictably North American traders used the most high frequency strategies with Europe not far behind, while Asia Pacific and the rest of the world tended to use these strategies less intensively.
There were no real surprises on the current asset class distribution. Three quarters of responses involved equities, a little over half used equity derivatives, while well over a third traded currency products. Commodities and their derivatives made up nearly 29% followed by fixed income cash and derivatives (19% and 25% respectively). Buy side firms tended to mention more asset classes than sell side or other firms, but that may just reflect a less siloed approach to trading and a more horizontal view of what is happening. The North American responses included overall much more emphasis on fixed income and commodities than seen from other regions, although on the buy side Asian Pacific traders actually reported the widest current use of equity derivatives and commodities, for example.
Over the next couple of years, trading in non-equity instruments is expected to grow strongly, with multiple asset classes catching up with equities in some regions, while fixed income is expected to lag a bit behind. The strongest growth is foreseen in buy side trading of FX and commodities' instruments in Asia Pacific and North America with two thirds of firms expecting soon to trade them, but equity derivatives also are forecast to catch up with equities in most jurisdictions.
The survey reflects strong expectations of growth reported by over 80% of participants. Buy side firms were the most bullish with over half expecting their high frequency flow to grow next year by over 25%. The strongest growth is forecast in the EU and Asia Pacific, while in North America growth appeared a bit weaker, perhaps due to the higher base. Indeed, around 10% of responses there actually forecast a decline next year.
Predicted HFT Growth Over Two Years (all respondents)
Participants were asked to describe one of their 'typical' high frequency trades to illustrate the range of practice. 35% chose a market making algo, 37%, a systematic trading algo, 24%, a smart order routing and slicing algo, while a few described a dynamic hedging algo. This suggests that the survey was at least representative of a wide range of experience and usage.
The compute platform for these typical trades was usually described as having between 2 and 16 cores, ignoring data feed handlers, with a majority of participants using not more than four. Around a quarter of day traders used a single core, while a few investment banks and others said they used over 64 cores spread across a number of servers. Larger configurations tended to be in North America. As the number of cores on a chip continues to grow, this suggests technology costs for high frequency trading should similarly continue to decline, further reducing the barriers to entry.
45% of typical trades involved only one or two markets. A further 45% apparently managed up to 10 liquidity centres, while only around 10% managed more than 10 centres.
Systematic algos tended to be somewhat slower, with around half generating only up to 1 order in the peak second. Market making algos were much faster with nearly two-thirds peaking at more than 50 orders per second. Smart order routing and slicing algos were described right across the order generation spectrum with around half claiming to peak below 5 orders per second and half above. Based on the small sample of dynamic hedging algos they appeared typically to peak below 1 order per second, but at least one claimed to generate over 500 per second. All regions provided examples of all frequencies, although North America and Asia Pacific both tended to describe algos somewhat faster than the European examples.
The algos varied hugely in terms of the number of passive orders a single algo might manage concurrently and the expected ratio of orders per trade. Market making algos tended to manage more passive, executable orders with higher ratios of orders per trade. 37% were managing more than 100 exposed orders and 12% were managing more than 1000, peaking at over 10,000. 50% of these market-making algos issued more than 20 orders per trade. In comparison only 23% of the systematic algos managed more than 100 exposed orders and only around 5% managed over 1000. They also tended to have higher hit ratios, with 70% issuing less than 10 orders per trade. Smart order routing and hedging algos were again spread broadly over the spectrum with some managing as few as one exposed order while others were claimed actually to manage over 10,000. Both tended to have higher hit ratios, the vast majority (90 to 100%) issuing less than 20 orders per trade.
Alpha horizons also varied with market making algos typically working in milliseconds to minutes, while systematic algos might more typically hold assets for minutes to hours and sometimes for weeks or months. Smart order routing algorithms were of course not typically concerned with alpha horizons, although some people suggested a wide range of alpha horizons were used.
Technical architectures are clearly advancing rapidly. Just over half of all responses already had distributed their trading servers, while the rest still traded from a single location. Across all regions a single trading centre typically appeared to mean the firm's proprietary data centre, but for high frequency work it might sometimes be colocated at the exchange or in a multi-tenanted proximity hosting centre. Where distributed trading servers were deployed, there was a small preference for exchange colocation, but proximity data centres and sometimes even proprietary data centres were also used. Around one third of these distributed trading servers were actively collaborating in real time with each other, while the rest were operating independently. Asian traders had more distributed servers working independently, typical for the region with long inter-market latencies, while in Europe and North America with more clustered markets the more typical architecture was still to have trading servers in one location, although more distributed architectures were also described.
Where multiple trading engines were used, nearly half of participants said they dynamically positioned individual orders, while a further 40% positioned orders by a fixed rule typically with a manual trader override. Less than 10% claimed there was no real-time decision at all regarding algo positioning. Somewhat surprisingly, perhaps, Asia Pacific appeared to have relatively the most dynamic positioning, Europe and the rest of the world had the least, while North American responses were evenly split. The buy side also appeared to use more dynamic positioning than the sell side.
Market access was provided by in-house algos and broker DMA in over half of cases, although for North American buy side firms there seemed a preference for sponsored access. Direct exchange memberships were also used in nearly half of cases across all types of trader. On the buy side direct memberships were somewhat more prevalent in Europe than in North America. Third party broker algos or sponsored access were generally said to be the least common methods of high frequency access across all regions. That may reflect more on the particular sample captured by the survey, since many long-only buy side firms who use broker algos, might not have responded to the survey or, if they did, may not have considered themselves to be using high frequency techniques for this flow even though they were.
The range of market data being consumed by high frequency algos is also diversifying rapidly. The survey highlighted two important trends: increasing use of full depth and cross-asset pricing data along with a range of new, more exotic data feeds.
Traditional market data includes top of book and full depth pricing data, plus post trade feeds. Of those responding to market data questions, 63% said they used cross asset data in their high frequency algos. This was fairly consistent across regions ranging from 52% in Asia Pacific, to 65% in Europe and 71% in North America. For full depth pricing data the responses were somewhat higher and clustered tightly around 70% in all regions with only the rest of the world 'region' dropping to 60%. However, in only 30% of cases did participants report use of post trade data in their high frequency algos.
The use of exotic or non-traditional data feeds is clearly another growing trend. 43% of responses on market data indicated some use of technical (32%), newsflow (21%) or liquidity indicator (12%) data feeds. Technical signals included latency measurements (22%), or queue lengths and similar metrics (19%). Liquidity measures focused on IOIs or similar indicators, while newsflow signals were either event or machine readable newsfeed data (15%) or else sentiment or other news metrics (10%).
Exotic data feeds in Asia Pacific tended to be used more heavily on the buy side, while in North America it was much more on the sell side and in Europe, split fairly evenly between buy and sell side. Note also that no one reported using news sentiment in Asia Pacific, while otherwise the exotic feeds were used generally across all the regions.
Most participants said they developed their high frequency algos in-house, while one-third use a third-party modelling framework for this. When it came to production, just over half use a third-party OMS/EMS framework, although a few have customized this heavily. European traders were more inclined to use an internally developed run-time environment (59%), whereas traders used third party products for this in North America (58%) and especially Asia Pacific (63%).
Risk and Performance Management
Overall the most important challenge was said to be dealing with data volumes, mentioned in half of responses (50%), with a fraction less mentioning the achievement of low latency (over 47%). However, in Asia Pacific these priorities were reversed. The buy side was also a bit more focused on latency than the sell side. Controlling DMA and sponsored access was the third greatest concern (just under 47%) or otherwise managing the real time risks (39%). No one claimed that finding alpha was a challenge! However, resolving errors and technology failures was a worry in around a quarter of cases.
Two thirds of high frequency traders used dynamic hedging to manage risk, with around half of those always hedging. Buy side traders were more likely to hedge than the sell side. Not surprisingly, those who typically do market making were much more likely to hedge than those doing systematic trading or smart order routing.
Where traders typically used long-short market neutral strategies or otherwise claimed to typically hedge their high frequency flow, they also claimed, not unreasonably perhaps, their strategies tended to consume less capital than their low frequency activity. So risk strategies appear to be tightly linked to the particular trading style. While over half of traders claimed they might equally apply high frequency strategies to long only, short or market neutral trading styles, many confirmed that they either applied the same risk strategies to both high and low frequency flow or else that the risk strategy depended on the specific trading strategy rather than just the speed of trading operations.
In any case 87% of high frequency traders still said they managed risks in real-time. The numbers were a little higher for the buy side, but rather lower (70%) for the sell side. Those whose typical high frequency strategy involved market making or systematic trading also did rather more real-time risk management, while those doing smart order routing and transaction hedging did somewhat less. Perhaps if the trading algos are doing their own dynamic hedging, separate real time risk management is less critical. This in any case might help to explain the lower sell side figures, which otherwise seem a little puzzling and perhaps accidental.
Top Business Challenges
Just under half (46%) said they held capital only against their executed real-time position, while over 30% held capital against both their executed and potential exposed position, continuously assessed in real-time. The remainder just calculated their risks against executed positions periodically or at end of day. Asia Pacific and Europe had the highest rates of real-time risk management for market making (88% and 82% respectively), while systemic traders in those regions had relatively lower rates (56% and 67% respectively). North America had somewhat lower rates for market makers (75%), but higher for systematic traders (82%). However, since we are talking about rather small sample sets for each sub-category, the broad trends are probably more significant than the precise numbers.
To measure performance the participants mainly tended to use Sharpe Ratios (50%), net absolute returns (45%), maximum drawdown limits (39%) or risk weighted rates of return (34%). Only around a quarter said they used value-at-risk measures for their high frequency trading with rather a greater emphasis in Europe than elsewhere. The Sortino method, which is similar to Sharpe but aims to differentiate good (upside) from bad (downside) volatility, was used in 23% of cases overall and more in the US on the sell side than anywhere else. A few traders used time-weighted rates of return (20%), index comparisons versus published indices (14%) or comparisons versus competitors where fund classification benchmarks were available (8%). One firm used return versus the number of messages sent, another arbitrage firm compared the required funding rate to a hurdle rate, while a third used a variety of unspecified in-house measures. No other specific performance measurement techniques were mentioned.
When asked to specify where regulators might usefully intervene in the market, a majority actually called for minimum levels of risk management for trading and clearing members of exchanges or other electronic trading platforms and also for minimum capital requirements for intraday exposures under various stress scenarios. Clearly they felt that would level the playing field. Flash orders were also seen to be ripe for regulatory intervention by 40%. So-called naked sponsored access, more prevalent in the US rather than Europe, was also considered potentially in need of intervention. 28% felt that co-location and equal access rights for high-speed traders might be useful. However only 12% thought that short selling uptick rules were needed. Note that the SEC had only recently brought in a new rule here to deal with rapidly falling markets. So the view on short selling might have been influenced by the current proposals. In any case, the community does seem to be open to discussion on common rules on quite a range of issues.
The Way Ahead
Participants in the Automated Trader survey were a self-selected community of people using these techniques, so it is not surprising that advanced methods appear with some regularity. However, since high frequency flow is starting to dominate many markets, the absolute size of the community does not detract from their importance.
It is clear that the leading edge of this group is comfortable at speeds above 500 or even 5000 orders a second, maintaining thousands of open positions across quite a wide range of markets distributed across a growing number of trading servers and cores, co-located at exchanges or in proximity hosting centres. The number of firms already using distributed yet collaborating trading engines across multiple asset classes and large numbers of markets is perhaps the most dramatic finding. While larger firms often achieved higher scale operations, the survey also showed smaller firms to be at the forefront of innovation and also speed. The competitive barriers are well and truly coming down.
Therefore, best practice has to involve a growing mix of data feeds across asset classes, including news, technical and liquidity data. It probably also needs to demonstrate ultra real-time performance and risk management including automated hedging with capital held against both exposed positions as well as actually executed trades.
Given the projected growth for existing players and the inevitable attraction for new players with falling technology costs and ever more services offerings, market data rates are likely to continue to rise exponentially especially once cross asset trading and news flow really kick in. As competition intensifies, the challenges will thus grow quickly even for the fleet of foot or deep of pocket.
During the recent flash crash on 6 May in the US markets, we saw what can happen when high frequency flow either spikes, betting on reversion, or simultaneously withdraws, avoiding the maelstrom. We can confidently expect many more exciting roller coaster rides to come. Regulators should take note of the current openness of the community to sensible rule making, before future crashes bring more painful but predictable surprises. More importantly regulators need to understand where the market is heading as well as whence it has come.
Yet the survey clearly illustrates the many risks lurking both for the unwary, slower trader and for the high frequency players themselves. High frequency flow provides liquidity, cross-asset predictability and dramatic economies of scale for the investor at the cost of embedded leverage on the tail risks. Thousands of messages per second and tens of thousands of exposed open orders per robotrader assume liquidity will persevere or an orderly disengagement can be managed. When sentiments darken and that liquidity begins to melt away, the cherished predictability can suddenly disappear. Without an appropriate market infrastructure the regime can break down in seconds.
Market organizers and regulators must now make the markets safe for high frequency. Indeed this survey should give food for thought for all market participants. The skills demanded are obviously ramping up with grim determination. Change continues to accelerate everywhere. That, perhaps more than just the speed of today's traders, is the most important conclusion for us to draw from this survey. By lifting the veil on all this highly secretive innovation, the Automated Trader 2010 survey on high frequency trading will undoubtedly spur on some to invest, encourage others to rethink their strategies and hopefully call market organizers and regulators to action stations. Markets are evolving very quickly indeed.