Lately, as the topic of High Frequency Trading has gotten front page prominence, there has been much confusion as to the top line impact on traders that utilize HFT methods, and inversely how much of a "toll" on investors high frequency trading is. In other words: what is the cost of liquidity?
Some, such as the TABB group estimate this to be roughly $20 billion a year. Others, such as John Hempton believe this number is a huge exaggeration, and that HFT is practically a philanthropic act of shareholder-focused pro bono activity, practiced on behalf of benevolent banks and magnanimous market makers, armed with massive collocated computers.
Zero Hedge decided to take a look at the facts. Conveniently, none other than specialized brokerage ITG (whose CEO Robert Gasser incidentally recently banned 3rd party algorithms from accessing its POSIT dark pool, and told analysts on the day of the decision that 'third-party dark aggregation has not been beneficial to our institutional POSIT constituency.' One wonders why SIGMA X is an exception in this regard) provides a historical trend in what is known as Implementation Shortfall costs, which allows one to determine HFT liquidity-provision costs.
Implementation Shortfall, also known as Slippage, is the toll HFTs collect from investors - this is, on average, the cost of spread and frontrunning. As per ITG's definition:
Implementation Shortfall (IS) Costs – comprised of 2 pieces:
- Timing Delay Costs - Any delay cost incurred between the Initial Decision (Open on Day 1) and the Broker Placement Price. Think of this as the cost of Seeking Liquidity.
- Market Impact Costs - Price change between the time the Order is placed with the Broker and the eventual trade price.
What is the numeric representation of IS costs? ITG provides a historical breakdown here:
The first immediately obvious thing is the gradual decline in Commission Costs over the past 5 years, as traditional venues for trading have been replaced with commoditized, HFT trading protocols: this has forced agents to compete based on cost, driving commissions ever lower: without doubt a benefit to investors who have reaped this one particular benefit of HFT.
Yet what is troubling is that IS costs, which have been relatively flat over the past 5 years, skyrocketed over the second half of the past year, with a particularly notable jump in Q4 of 2008 - the days of the turbulent and volatile equity market post the Lehman collapse. Also, the dramatic increase in IS, which averaged 53 bps in 2008, is among the primary reasons why HFT operators in 2008 had a record year, and why firms like RenTec had a massive return difference between its market-neutral HFT strategy (Medallion, with 42% annualized returns since inception and a 5.3 Sharpe ratio over the last three years) and its long-short 175/75 quantitative strategy (RIEF, with deplorable returns). Also, the recent ramp up in HFT by firms such as Goldman Sachs via the NYSE's Supplemental Liquidity Provider program may be a major clue as to the record number of $100MM + trading days in Q1 and soon, in Q2.
So what is the bottom line? Observing the volume of NYSE stocks traded globally one gets an average number of just over 6 billion share daily.
Taking the 6 billion daily average, and applying an average stock price of $20/share and using the assumption that HFTs represent 70% of the volume, while capturing 50% (and according to Zero Hedge sources, this number could be as high as 90%) of the 53 bps average IS spread in 2008 results in HFT slippage capture of over $220 million daily on NYSE stocks alone. And this does not even count rebates. Taking this one step further, assuming 250 trading days in a given year, brings the total annual costs to investors (and revenues to HFT strategies) to over $55 billion. If one expands this methodology to non-NYSE member stocks and exchanges, a reasonable guess for HFT tolls in the US alone to be over $100 billion.
One can see why HFT is a sacred cash cow for the limited group of participants who benefit from "providing liquidity."
Recently, the market cap of U.S. listed stocks was just under $12 trillion: if the total annual cost to investors is indeed in the $100 billion ballpark, which they fork over to the likes of Goldman, RenTec and others for providing liquidity, it means that the liquidity premium of stock trading has increased to 0.8% of total assets.
Of course, arguments can be made that this is a fair price to pay in exchange for having daily liquidity available (although the debate of whether liquidity=volume is highly relevant) at our fingertips provided by thousands of computers which trade millions of shares every second. The bigger question is what is the potential for abuse of this highly under the cover P&L item, and have firms such as Goldman simply become a toll aggregator as a result of persistent stock churning and liquidity provisioning. As $100 billion is over 0.5% of the recently released GDP, does it not make sense to more actively evaluate whether the HFT market would benefit from some substantial anti-trust intervention, which in turn would promote higher competition and the break up of the highly profitable trading monopoly of a very select few?