Schaeffer's Trading Floor Blog

Can HFT Save Rising Transaction Costs?

Is there causation between transactions costs and high-frequency trading?

by 2/25/2014 7:28 AM
Stocks quoted in this article:

The market has essentially churned for the first two months of 2014, which suggests that a more active trading strategy should be a value-add. Let me rephrase that -- active trading could be a value-add you still have to trade well. The bar is simply lower when you're trying to beat 1% returns of buy and hold then if you're trying to beat the monster gains of 2013.

Before you start flipping more actively though, keep in mind that your transaction costs may have started to trend higher. At least, that's the conclusion of Credit Suisse, according to this MoneyBeat article from The Wall Street Journal.

I found the conclusion somewhat surprising, but I find their explanation even more surprising.

Costs have been rising across all regions of the world, though they still remain the lowest in the U.S. "Asia is more than twice as expensive to trade," they write.

The pair also blame new regulations -- such as "transaction taxes" in Europe and the crackdown on proprietary trading in the U.S. -- and the shutdown of a number of high-frequency trading firms for higher costs.

"Both Europe and the U.S. have since seen a reversal of some gains in their transaction cost indexes over the past two years," the analysts said. "Coincidentally or not, the reversal in cost indexes occurs at around the same time that HFT is reported to have peaked in each region."

High-frequency trading (HFT) has apparently followed the path of every market niche ever. The early adopters make a killing, which draws more and more players into the field. The increased competition drives profit margins to near zero, which culls the crowd. But generally speaking, the big margins don't come back again. Now, HFT, of course, is more of a volume model. The margins were always tiny; the lightning speed of the "machines" allowed them to capture the tiniest of edges in huge size. But the same dynamics as always still come into play.

Now, I'm hardly a fan of the algorithms. I never bought the argument that they added liquidity. But, it's certainly interesting to note the correlation between their activity and transaction costs. I'm not sure I buy the causality though, at least as far as we humans are concerned. Part of the HFT model involves generating volume-based rebates. So, even though some measure of the average transaction cost decreased when HFT peaked, those reduced costs were primarily realized by the machines, not you and me. If they've indeed cut back, or their market share has decreased, average transaction costs will decline, but yours and mine maybe just stayed the same all along.

It's the same principle as if you added a great hitter to a team's batting order. The team batting average will lift even if every other player performs exactly as they did before. Take the great hitter away, and the team's batting average will decline back to where it was before they added the big bat.

Is that what's going with the calculation of these transaction costs? I'm honestly not sure, I don't know their methodology. I would suggest, though, that before we go asking The Machines to step up their game, we need to find out whose costs exactly are rising.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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