Streetwise Professor

June 12, 2013

Creative Destruction and Vanishing Profit, HFT Edition

Filed under: Economics,Exchanges,Regulation — The Professor @ 8:15 pm

And now for something completely different.

HFT has been a bugbear for several years now.  The monster that would eat the equity markets, and then move onto derivatives for dessert. But HFT has apparently fallen on (relatively hard times).  HFT volumes are down.  HFT market shares are down.  And most interestingly, HFT profits are down, by about 50 percent on a per share basis, more on a gross basis because volumes are down.

This should not really be a surprise.  Basic economics predicts when profits in a particular activity are high that entry, the expansion of existing firms, and the development of competing technologies will dissipate those profits.

It’s interesting in this context to think about Schumpeter’s argument in Capitalism, Socialism, and Democracy.  One motivation for the book was to examine whether there was, as Marx and earlier classical economists predicted, a tendency for profit to diminish to zero (where costs of capital are included in determining economic profit).  That may be true in a totally static setting, but as Schumpeter noted the development of new, disruptive technologies overturns these results.  The process of creative destruction can result in the introduction of a sequence of new technologies or products that displace the old, earn large profits for a while, but are then either displaced by new disruptive technologies, or see profits vanish due to classical/neoclassical competitive forces.

Whether it is by the entry of a new destructively creative technology, or the inexorable forces of entry and expansion in a technologically static setting, one expects profits earned by firms in one wave of creative destruction to decline.  That’s what we’re seeing in HFT.  It was definitely a disruptive technology that reaped substantial profits at the time of its introduction, but those profits are eroding.

That shouldn’t be a surprise.  But it no doubt is to many of those who have made apocalyptic predictions about the machines taking over the earth.  Or the markets, anyways.

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  1. It has always been likely that HFT activity would be a cyclical phenomenon.

    Once the smartest ones have relieved all the others of their money, what will be left will be the smartest ones with every conceivable edge deployed (co-location, quantum processors, etc) picking up pennies from in front of steam rollers.

    Without algoes to damp the volatility there will surely be more of it, which will draw new algoes in.

    I would think.

    Comment by Green as Grass — June 14, 2013 @ 8:50 am

  2. @Green-speaking of volatility, the decline in volatility in the past year-plus is likely also contributing to the decline in HFT volumes and profits.

    Generally I agree with your prognosis of how this will play out. There was a technological shock, and intense competition to implement systems that could exploit this technology. The shakeout/survival of the fittest process is now going on. I think we are near the steady state until the next technology shock.

    The ProfessorComment by The Professor — June 14, 2013 @ 1:42 pm

  3. Professor, to me the situation is similar to the U.S. power markets of late ‘1990s and up to middle to somewhat 2003-05.
    The pockets of loads and the shortages of power supply where it mattered created significant opportunities for the peaker plants. But with the construction of new plants and the departure of a few wholesale energy companies (Enron, Mirant, Williams, etc.) from the market the equilibrium was quickly reestablished.
    Continuing the analogy, I think all trading firms – small, large, HTF or not, should reserve HFT capacity from corresponding service providers. A fee structure of a capacity charge plus a demand charge, much like in power markets, can be structured. I think it will further level the field, save cost to the trading firms and assure them ability to quickly liquidate positions when it is needed. At least I would like to hope that this is a workable business model.

    Comment by MJ — June 15, 2013 @ 10:04 am

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