How big is high-frequency trading?

By Felix Salmon
July 30, 2009
TABB Group. In a recent publication, TABB's Robert Iati writes:

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I have a bit more clarity on the $20 billion figure for total profits from high-frequency trading: it comes from the TABB Group. In a recent publication, TABB’s Robert Iati writes:

TABB Group estimates that annual aggregate profits of low latency arbitrage strategies exceed $21 billion, spread out among the few hundred firms that deploy them. While we know all the large investment banks such as Goldman Sachs are committed to prop trading profitability, the hundreds of smaller, private high frequency prop shops extend much greater influence in the marketplace by providing liquidity that keeps activity flowing.   

The Bloomberg article, meanwhile, explains the figure thusly:

The firms compete for a slice of $21.8 billion in annual profits from equities and derivatives market making and arbitrage, according to Tabb. Among the largest are hedge funds Citadel Investment Group LLC, D.E. Shaw & Co. and Renaissance Technologies Corp., as well as the automated brokerages Getco LLC, Hudson River Trading LLC and Wolverine Trading LLC.

When John Hempton, then, says that “quantifications of this as a $20 billion issue are insane”, I think there are two questions: firstly, what is “this”, and secondly, how profitable is it, in aggregate.

It would be most convenient if the HFT algorithms were split nicely into a “trading” bucket and a “quant arbitrage” bucket, so that Hempton could complain mildly about the “trading” algos while saying at the same time that they’re not all that big of a problem, while ignoring the stat-arb shops and other high-frequency, low-latency traders. But in reality there’s very little difference: the traders all have strategies, and the stat-arb strategies are all implemented so as to maximize trading profits.

To put it another way, I don’t think people are making billions of dollars in profit just by being fast. But there are definitely people making billions of dollars in profits through strategies for which being fast is a necessary precondition.

Which leads us to the second question: if you tot up all the profits from high-frequency, low-latency traders, including big shops like Citadel, Renaissance, and Goldman, can you get to $20 billion? My gut feeling is that you can, and that the TABB estimate is not obviously unreasonable.

I also got a note from Jon Stokes yesterday which is worth disseminating more widely:

It’s quite remarkable to me that many of the econ and finance folks who insist that “HFT is the same thing we always did, just way faster” don’t seem to realize that frequency and amplitude matter a whole lot, and that for any given phenomenon when you suddenly increase those two factors by an order of magnitude you typically end up with something very different than what you started with. This is true for isolated phenomena, and it’s doubly true for complex systems, where you have to deal with systemic effects like feedback loops and synchronization/resonance.

What I’ve noticed anecdotally is that engineers and IT pros are more concerned about HFT than people who just handle money for a living. These guys have a keen sense for just how fragile and unpredictable these systems-of-systems are even under the best of conditions, and how when things go wrong they do so spectacularly and at very inconvenient moments (they get paid a lot of money to rush into the office to put out fires at 4am).

There’s an analogy here with e-voting, which I did quite a bit of work on. In the e-voting fiasco, you had people who were specialists in elections but who had little IT experience greenlighting what they thought was an elections systems rollout, but in actuality they had signed on for a large IT deployment and they had no idea what they were getting into. To them, it was just voting, but with computers, y’know? They found out the hard way that networked computer systems are a force multiplier not just for human capabilities, but for human limitations, as well.

This is why I’m sympathetic to Paul Wilmott’s view of all this: there’s simply too much complexity here for comfort, and too many things which can go wrong. When the stat-arb shops imploded in the summer of 2007, the systemic consequences were mild-to-nonexistent, and that does provide a certain amount of reassurance. But we can’t be sure that if and when such a thing happens again, the consequences won’t be much worse.


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It’s not very hard to get to $21 billion if you count all electronic proprietary trading as the TABB report does, but that was not what the HFT meme was about, it was about rebates, flash orders, dark pools, etc, all things that have to do with the “maker-taker” model and not with the superset of algo trading.
As for complexity, a distributed system of market making is a lot more robust than a central one. I have never seen the fx close down because of computer problems.

Doesn’t the two to one leverage limit in stock trading put a serious damper on the systemic consequences of a HFT failure?

Typical NYSE volume is $55B/day for close to $12.5T/yr. At a 0.1% ‘tax’ would yield $12.5B, just from NYSE. On a $20 stock, that is a $0.02 difference.

Posted by winstongator | Report as abusive

So… worst case scenario?

Unpredictable complexity of separate-but-interacting algorithms cause a standing wave resonance that destabilizes the market with catastrophic results.

Having programmed computers for the last quarter century, I must say that such a scenario sounds plausible.

But just as unpredictable as earthquakes.

Posted by Bryan X | Report as abusive

On July 9th I asked the rather silly question, “Are equity markets starting to lase?” but after reading what Stokes was saying above I don’t feel quite as bad about that one.

At the risk of being totally politically incorrect, might I suggest that the configuration has now advanced to something that feels like a group of grumpy tigers racing faster and faster around some fictional tree near Madras?

most excellent post

Posted by Matthew Goldstein | Report as abusive

Felix: I appreciate that we are on different sides of this issue, but you’ve been very fair and thoughtful in dealing with it. In that same spirit, I was hoping you might take a look at Eric Falkenstein’s post (and mine, if you’ve got a couple of extra secs) and let me know your take. Thanks! t-has-never-been-fairer-for-the-retail-i nvestor-2009-7  /bovine-scatology.html

Felix says: “It would be most convenient if the HFT algorithms were split nicely into a “trading” bucket and a “quant arbitrage” bucket…”

In your previous post on HFT you compared it to a “liquidity tax”. But isn’t this the difference between market-making and stat arb? The quicker trading algos could be said to “tax” slower market makers (which is still irrelevant to anyone who holds longer than a daytrader). In what sense do stat arbs tax anyone (except maybe other arbs)?

Posted by tc | Report as abusive

One way to distinguish the stat arb component from that which is due to HFT is to modify the market mechanism from continuous to discrete time. Let the market aggregate orders over a one-second period, during which no information is revealed. That would level the playing field by removing all advantage from sub-second speed premiums.

“Unpredictable complexity of separate-but-interacting algorithms cause a standing wave resonance that destabilizes the market with catastrophic results.”

OK maybe. Can we make a distinction between high-frequency and algo trading? For me high-frequency trading is about making short-term in and outs – buy because you think someone else is buying, then sell it back a little while later. So the book is squared at the end of the day.

On these terms high-frequency trading does not have any overnight risk. If you have a money-spinner with no overnight risk, that’s a pretty sweet activity.

OK, the quote is talking about intraday risk, that all that HFT might swing the markets in unexpected directions and cause lots of money to be lost. Who knows, maybe that’s what we experienced in the fall of 2008? A couple of -9% and +10% days. Is anyone, though, claiming those days were a result, even in part, of HFT? As I understood it, in volatile days, they just switch the HFT computers off, and that’s one reason why they become so volatile, because liquidity has evaporated.

Posted by a | Report as abusive

As someone who trades I see how these things create instability. you can see how they encourage too much buying when things are going up, and too much selling when things are going down. I believe they promote a boom and bust cycle. If you are trading it becomes almost impossible to trade on a rational basis. Is there anyone out there that believe things would have gone up so high so fast if these things weren’t there. same with the market crash, it happened in recrd time

Posted by dcb | Report as abusive

Using Quant trading programs to buy and sell the same stock thousands of times a day creates artificial volatility. This high frequency trading manipulates the VIX. This allows the large trading houses to sell put and call options at inflated pricesi in a flat market.

Posted by Rockford | Report as abusive

Those of us here familiar with the theoretical tension between the irrational speculator and the informed arbitrageur may see the same dichotomy and trading between comments here.

I’m just wondering:
1. How can providing liquidity be a tax on liquidity?
2. How could high frequency trading counterparties all collude to load up one side of the market and then puke the other way, simultaneously? The essence of HFT is to arb out the pennies, and flatten out positions (perhaps through more complicated reversal/conversion); not to take risk positions for days, hours, or even hours on end. You can see this if you compare the prime brokers’ markets for intraday vs. overnight leverage.

I think we get Michael Moore, Oliver Stone, and Felix’s fave Ben Stein here to solve the problem once and for all!

Do the so called circuit breakers apply to this type of trading?

And is anyone looking out for positive feedback loops in these systems? As many an engineer knows, they tend to be unstable and then blow-up.

Posted by Larry | Report as abusive