The Arms Race in High Frequency Trading

If the calls I am getting from headhunters are any indication, the hot area now is high frequency trading. And no wonder. There are two areas that were spared in the 2008 debacle: macro and high frequency trading. Macro funds on average were up ten percent or so last year because most of them skirted the edge of the major dislocations; their strategies focus on liquid instruments and are not oriented toward credit. High frequency trading did well because it thrives in an environment of high volatility and demand for liquidity, and 2008 was a hot house for both. Every year, people pile on to whatever strategy did well the previous year – this tendency is worth a book or two on its own – and so this year high frequency is destined to be the darling of the fund of funds.

But I think the days for high frequency trading are numbered. For one thing, high frequency trading is capacity constrained like few other strategies. The high frequency trader is basically a stand-alone market maker; he is sitting there to provide liquidity to others. And one way he provides it is to pull in the positions that others will shortly be demanding – thus the need for speed. If the footprint for high frequency traders gets too large, they become liquidity demanders themselves, and the gig is up. The Renaissances of the strategy will make their way through, but generally we will see a lot of shooting stars.

A second reason is that high frequency trading is embroiled in an arms race. And arms races are negative sum games. The arms in this case are not tanks and jets, but computer chips and throughput. But like any arms race, the result is a cycle of spending which leaves everyone in the same relative position, only poorer. Put another way, like any arms race, what is happening with high frequency trading is a net drain on social welfare.

In terms of chips, I gave a talk at an Intel conference a few years ago, when they were launching their newest chip, dubbed the Tigerton. The various financial firms who had to be as fast as everyone else then shelled out an aggregate of hundreds of millions of dollar to upgrade, so that they could now execute trades in thirty milliseconds rather than forty milliseconds – or whatever, I really can’t remember, except that it is too fast for anyone to care were it not that other people were also doing it. And now there is a new chip, code named Nehalem. So another hundred million dollars all around, and latency will be dropped a few milliseconds more.

In terms of throughput and latency, the standard tricks are to get your servers as close to the data source as possible, use really big lines, and break data into little bite-sized packets. I was speaking at Reuters last week, and they mentioned to me that they were breaking their news flows into optimized sixty byte packets for their arms race-oriented clients, because that was the fastest way through network. (Anything smaller gets queued by some network algorithms, so sixty bytes seems to be the magic number).

If we get out of the forest and look at what is going on, some questions come to mind. Does anyone really get a benefit in having the latency of their trade cut by milliseconds – except for the fact that their competitor is also spending the money to cut his latency? Should anyone care if a news event hits market prices in twenty-nine milliseconds rather than thirty milliseconds? Does it do anything to make the markets more efficient? Does it add any value to society?

We usually do not think about trading in terms of social value, but trading often does have social value, and it should. The objective of trading is to provide liquidity to the market, and to make sure that prices best reflect all available information – the usual efficient market argument we all grew up with. The solution? How about having everyone agree to standards in terms of hardware and related configurations. A high-frequency arms limitation treaty. We could call it HALT.


Originally published at the Rick Bookstaber weblog and reproduced here with the author’s permisssion.

6 Responses to "The Arms Race in High Frequency Trading"

  1. Anonymous   April 22, 2009 at 12:18 pm

    You obvioulsy don’t really understand the actual expense associated with HFT hardware and software. Based on your comments, I’ll bet your thinking is off by at least an order of magnitude in every magnitude you’ve referenced. Do you really think that entrenched interests want to push latency lower? What if I told you that the fastest was also the smallest and and quite affordable, not server farms? I don’t think you really know what you’re talking about. Really, you are far off the mark.

    • Anonymous   April 26, 2009 at 3:49 am

      I guess I have to agree with this guy. The article brings too few information about what HFT really is. A long time ago (1996) I was in CBIT discussing with chip fabricants about building whatever I needed in the chip directly. Forget large servers. The only point this may have made is indirectly. If many people begin to do the same in the same field then chances are high that it becomes close to a fair game. Then comes the necssity of newer tricks and so on. But then extend the horizons … and so on.

  2. Anonymous   April 26, 2009 at 7:23 pm

    Sir,what astonishing ” news ” you are posting?” The various financial firms who had to be as fast as everyone else then shelled out an aggregate of hundreds of millions of dollar to upgrade, so that they could now execute trades in thirty milliseconds rather than forty milliseconds – or whatever, I really can’t remember, except that it is too fast for anyone to care were it not that other people were also doing it. And now there is a new chip, code named Nehalem. So another hundred million dollars all around, and latency will be dropped a few milliseconds more. “Those financial firms you mentioned would not even spend 1 millisecond to look at a real time demo of my algorithm which simply flies by, global TV nation babblers.Disgusted…….http://www.bottomline.ie

  3. Guest   April 29, 2009 at 2:39 pm

    With all respect to Rick’s elitist background, in this article Mr. Bookstabber comes across as a peeved narrow-minded fascist left behind the gravy train.

  4. Guest   May 1, 2009 at 7:30 am

    Maybe all those hundreds of millions to Intel etc provide jobs for a lot of people?

  5. Guest   May 4, 2009 at 12:28 pm

    dude has no clue. And there aint no going back to i feel bad he decided to HALT on doing real research in the space rather than glazing us thanksgiving ham still with a pork article. I respect the different viewpoint but fact is it does not cost much to improve latency, these firms make 10x more per the cost of improvement and their continued involvement in the markets reduces the costs for Rick’s 401K manager to trade in and out of his dwindling portfolio. And Renaissance? Really? There’s about as high frequency as Accords are race cars.