Over the past year or two, a lot of digital ink has been devoted to technology wars that are re-shaping our capital markets. The terms latency, low-latency, ultra-low latency, high-frequency trading, algorithmic trading and naked-access have all entered our lexicon. We have gone from measuring execution times in seconds to milliseconds, to micro-seconds and nano-seconds, and now pico-seconds. Indeed, physical law -- the speed of light -- is now viewed by some as a limiting factor.
Let's look back and reflect at how far we've come, and where technology has brought us. In the 1990's, the FIX protocol was introduced. Coupled with the buy side's newest toy, the order-management system (OMS), the age of electronic trading was set to explode and go mainstream. At the time, there were the two primary equities exchanges, and a handful of ECNs. Bid/ask spreads were 1/16th (6.25-cents), and buy-side commission rates were often 4 or 5 cents per-share -- and I'd seen some higher! With these factors combined, and if a trade was executed on the "wrong" side of the spread, firms were paying an effective rate of 10-cents per share, or more.
What's happening today?
Let's fast-forward to 2011, present day. In today's markets, penny spreads are the norm, except for very thinly traded issues. And the largest buy-side firms routinely can execute at a 1/2-cent per share commission rate. Use of a mid-point match algorithm can make the effective spread 1/2-cent, and less if willing to use a passive algorithm that attempts to buy at the bid, or sell at the offer. So what's the net result? Executions today cost buy-side firms only a penny or less -- 1/10th the cost of the early 90's, which leads us to what we see today: a stark bifurcation of the market, dividing investors and traders.
Traders measure their "investment" time-horizons with a stop-watch. Their rapid-fire computers detect, and often predict, minute statistical arbitrage opportunities and market-pricing inefficiencies, and then generate trades to capitalize. To the largest firms, often trading 1 billion shares PER DAY, making a penny, or even a fraction of a cent per share, is all that's required to book a substantial profit. These firms spend untold millions on specialized hardware, co-location with the exchanges own computers, and rooms full of quantitative analysts and programmers. Speed is their friend, physics is their limitation, and you can never be fast enough.
For other market participants (investors), the presence of traders brings consistently tight spreads and greater depth of liquidity -- a symbiotic relationship. An investor, buying a specific stock when implementing a trade idea, typically has a time-horizon of 3 or more years on that position. Consider a hypothetical trade in 1990 that put $10 million dollars to work in XYZ Corporation, a $25 stock. XYZ then had market appreciation that averaged 10 percent per year for 3 years. With execution costs of 10-cents per share at both ends, 26 basis-points of investment-return "drag" was realized, reducing the effective return to 9.74 percent annualized. With execution costs now at a penny, the same trade today would have execution-cost impact of only 2.6 basis points -- a 90 percent reduction -- with the effective return now at 9.97 percent. Of course, the impact of execution-costs are even less when time-horizons are extended.
It's a fact that today's markets represent a mix of participants, with differing objectives and time horizons. This is nothing new. As illustrated, the buy-side benefits from increased automation of the markets. But they should also recognize that we are at or near a practical limit -- economics, and the law of diminishing marginal returns. Their capital investments over the past two decades, adopting (now) standardized technologies, have lowered costs, improved investment returns, reduced risks, and streamlined operations. We have shaved 90 percent off of the effective costs of execution. However, the incremental costs to reduce costs further, even another basis-point or two, could be enormous, stifling any ROI arguments for all but a few of the largest buy-side firms. Simply put, the incremental benefits are not necessarily worth the incremental costs. For most investor firms, fast is now fast enough.
Where will technology bring us?
Technology will continue to advance and improve. But, from an investment return perspective, little improvement opportunity remains. I suspect that most investors will now shift their focus to higher-value opportunities in the never-ending quest for alpha returns.
Mark Volker is senior vice president of SunGard Global Trading.