So Sorry – How You Deal With That?

We loved the “traditional Chinese sarcastic dance” poking fun at iPhone 5 critics this past weekend on Saturday Night Live, and we just had to figure out a way to work it into a note this week!

We have written often about how HFT firms are like locusts – i.e. they will consume a field (equity market) until barren and then move on to other fields (overseas/asset classes). We have also written often on how we believe that as investors leave the equity markets, the HFT firms will begin eating themselves. This has really come to pass in 2012, as we have repeatedly heard anecdotal stories of how HFT firms have been suffering this year. In fact, whereas Tabb Group estimated HFT firm profits to be $21 billion for the industry in 2009, Rosenblatt just last week estimated this number to have fallen in 2012 to $5 billion.

These firms are having a tough time right now. Getco earlier this year cut jobs. Interactive Brokers revealed on their earnings conference call how:

Market Making trade volume was down 27% from the prior year quarter, spread across the product types. Options and futures contract volumes were down 36%, 38%, respectively, while stock share volume was down 40%.

And the Wall Street Journal yesterday reported that Eladian Capital has closed its doors. Eladian was the startup of Steve Swanson, of Automated Trading Desk fame, which Citigroup acquired in 2007 for nearly $700 million, and was funded with private equity money (Technology Crossover Ventures). According to the WSJ article:

Eladian’s closure comes as high-frequency trading firms broadly are facing difficulties sustaining profits, particularly from stocks, and many are seeking to expand in fixed income, foreign currencies and trading of other securities in the U.S. and abroad. They are also facing mounting criticism by regulators, lawmakers and long-term investors questioning whether trades measured in milliseconds are distorting asset prices and helping some of the fastest traders jump ahead of others.

Eladian’s closure raises an important issue that we hope the SEC is thinking about. Much of the HFT industry that our markets depend so heavily on for “liquidity provision” is in fact funded with private equity. Virtu Financial has Silver Lake backing. Getco has General Atlantic backing. TA Partners last year bought into RGM Advisors and Summit Partners bought into Flow Traders. Some HFT firms have stakes in each other (Getco/ Tradebot). What happens if HFT becomes unprofitable? What happens if the liquidity providers can’t get more funding from IPO’ing their stock? What happens if their private equity backers say that enough is enough?

To these firms we say “So Sorry. Must be so hard for you.” And to the SEC we say, “How you gonna deal with that?”