With Profits Dropping, High-Speed Trading Cools Down

High-frequency trading firms — the lightning-quick, computerized companies that have risen in the last decade to dominate the nation’s stock market — are now struggling to hold onto their gains.

Profits from high-speed trading in American stocks are on track to be, at most, $1.25 billion this year, down 35 percent from last year and 74 percent lower than the peak of about $4.9 billion in 2009, according to estimates from the brokerage firm Rosenblatt Securities. By comparison, Wells Fargo and JPMorgan Chase each earned more in the last quarter than the high-speed trading industry will earn this year.

While no official data is kept on employment at the high-speed firms, interviews with more than a dozen industry participants suggest that firms large and small have been cutting staff, and in some cases have shut down. The firms also are accounting for a declining percentage of a shrinking pool of stock trading, from 61 percent three years ago to 51 percent now, according to the Tabb Group, a data firm.

It is a swift reversal for trading firms that have often looked to other investors like profit machines, thanks to high-powered software and superfast data connections that can take advantage of small changes in the price of a stock.

High-speed trading is far from disappearing from the market, but the struggles facing these firms have been greeted with enthusiasm by some traditional traders and investors who have viewed the firms as formidable adversaries, or worse, market manipulators that create sudden spikes and drops in share prices. Peter Costa, a longtime trader on the floor of the New York Stock Exchange, said the fading presence of the firms could “restore some order to stock markets.”

Regulators are still grappling with whether the rise of high-speed firms has been a net benefit or loss for investors, so it is hard to pinpoint what effect the decline of these firms will have on the markets. Many market experts have argued that the technical glitches that have recently hit the market have been a result of a broader trend of the market splintering into dozens of automated trading services and a lack of human oversight.

The challenges facing speed-focused firms are many, the biggest being the drop in trading volume on stock markets around the world in each of the last four years. This has made it harder to make profits for traders who quickly buy and sell shares offered by slower investors. In addition, traditional investors like mutual funds have adopted the high-speed industry’s automated strategies and moved some of their business away from the exchanges that are popular with high-speed traders. Meanwhile, the technological costs of shaving further milliseconds off trade times has become a bigger drain on many companies.

Among the firms scaling back is the Chicago Trading Company, which this year earned a spot on a government committee formed to explore the emerging phenomenon of high-speed trading. Since then, the company has been making cuts to its New York office, according to people with direct knowledge of the moves. The company’s chief executive, Eric Chern, said some employees had been moved to Chicago and 10 had left the firm. He declined to comment directly on the changes, but he did say that “the market environment always plays a factor in all our decisions.”

Douglas Cifu is the president of Virtu Financial, a big player in the industry. “There was this mythology that you could get 90 computers, some Harvard Ph.D.’s and you would turn on your machines and make money,” he said. “It’s just not the case.”

Virtu has not cut back, but it has acquired smaller firms that were struggling to continue operating on their own. Last month, Virtu bought Nyenburgh, a company that specialized in the most popular type of high-speed trading, known as market making, of European stocks.

At the same time that the firms are making trims, regulators around the world have increased their scrutiny of high-speed traders, and the structure of the financial markets has continued to shift. Executives at the trading firms worry that new regulations could curtail business even more, but so far regulators in the United States have taken few steps to rein in trading practices.

Beyond Wall Street, Curbs on High-Speed Trading

Industry leaders and regulators in several countries including Canada, Australia and Germany have adopted or proposed limits on high-speed trading and other technological developments that have come to define United States markets.

The flurry of international activity is particularly striking because regulators have been slow to act in the United States, where trading firms and investors have been hardest hit by a series of market disruptions, including the flash crash of 2010 and the runaway trading in August by Knight Capital that cost it $440 million in just hours. While the Securities and Exchange Commission is hosting a round table on the topic on Tuesday, the agency has not proposed any major new rules this year.

In contrast, the German government on Wednesday advanced legislation that would, among other things, force high-speed trading firms to register with the government and limit their ability to rapidly place and cancel orders, one of the central strategies used by the firms to take advantage of small changes in the price of stocks. A few hours later, a committee at the European Parliament agreed on similar but broader rules that would apply to all 27 member states of the European Union if governments also give their approval.

In Australia, the top securities regulator recently stated its intention of bringing computer-driven trading firms under stricter supervision and forcing them to conduct stress testing, to protect “against the type of disruption we have seen recently in other markets.”

The broadest and fastest changes have come out of Canada, where this spring regulators began increasing the fees charged to firms that flood the market with orders. The research and trading firm ITG found that the change had already made trading more efficient by reducing the crush of data burdening the market’s computer systems.

Now Canadian trading desks are preparing for rules that will come into effect on Oct. 15 and curtail the growth of the sophisticated trading venues known as dark pools that have proliferated in the United States. While the regulation has been hotly debated, many Canadian bankers and investors have said they don’t want to go any further down the road that has taken the United States from having one major exchange a decade ago to having 13 official exchanges and dozens of dark pools today.

“We don’t want to look like the U.S., but we have to do it better than we are now,” said Greg Mills, the head of stock trading at the nation’s largest bank, Royal Bank of Canada.

Canadian executives traveled to Washington last week to speak about what the United States may soon be able to learn from Canada about how to rein in the new high-speed markets.

“Because the U.S. had moved ahead so fast, we had the opportunity to watch and decide in some cases that there were extremes we didn’t want to go to,” Kevan Cowan, the president of the Toronto Stock Exchange, said at last week’s conference.

American regulators have faced a growing demand at home for some sort of market reform from traders and exchange executives. At a Senate hearing on computerized trading last Thursday, one market analyst called for a moratorium on the new trading venues that have popped up in recent years, while traders on the panel recommended mandatory kill switches that could be flipped in case of technology malfunctions. The senator who called the hearing, Jack Reed, Democrat from Rhode Island, said “our marketplace has been evolving very quickly and it is not clear that our rules have kept up.”

There are many explanations for the slower pace of reform in the United States, including the crush of work the S.E.C. has had to deal with in completing regulations under the Dodd-Frank financial overhaul law. In addition, many of the largest American market participants, including the big banks, have built high-speed trading desks and dark pools and as a result have a vested interest in protecting them against new regulations.

The soft-touch approach of American regulators has won praise from many industry participants around the world who say that the rush elsewhere to impose new rules could jeopardize the lower trading costs that have come with the automation of the American markets. Michael Aitken, the chief scientist at the Capital Markets Cooperative Research Center in Australia, said the push for regulation in Australia and much of the rest of the world has been driven by “hysteria” rather than “evidence based policy.”

This article has been revised to reflect the following correction:

Correction: September 27, 2012

An earlier version of this article incorrectly said that it was a European Union committee that agreed on high-speed trading rules; it was actually a European Parliament committee. In addition, the article said the rules would apply to the Continent; they would in fact apply to the 27 member states of the European Union if approved by the governments.

Germany Is Expected to Act to Curb High-Speed Trades

Chancellor Angela Merkel’s government approved draft legislation on Wednesday that foresees imposing additional controls on such trading. The proposed measures include requiring that all high-frequency traders be licensed, requiring clear labeling of all financial products traded by powerful algorithms without human intervention and limiting the number of orders that may be placed without a corresponding trade. Traders who violate the limits, which would be set once the law took effect, would face a fine.

“Computer-generated algorithmic transaction involves a variety of new risks,” Germany’s finance ministry said in a statement. “Germany is reacting to these risks with legislation that will create more transparency, security and a better overview.”

The legislation, which is subject to approval by both houses of Parliament, was written with an eye toward similar legislation being discussed in Brussels that could eventually apply across the European Union, which has 27 member nations, the official said.

Steps to pass the broader legislation on high-frequency trading are expected to proceed Wednesday, when the influential Committee on Economic and Monetary Affairs of the European Parliament will vote on how to update the law that governs securities trading to take account of new technologies.

The Europeans are not alone in their concern about high-speed computerized trading, which has led to several notorious market disruptions in recent years.

The latest occurred in early August in the United States, when problems with newly installed software caused the Knight Capital Group, a New Jersey broker that specializes in computer-driven trading, to lose $440 million. The problem led Knight’s computers to rapidly buy and sell millions of shares in more than 100 stocks for about 45 minutes after the markets opened on a Wednesday. Those trades pushed the price of many stocks up, and Knight lost money when it had to sell the shares back into the market at a lower price the next day.

The Knight episode raised alarms on Wall Street and in Washington, but no new curbs have yet been proposed for high-frequency trading in the United States.

In Berlin, German officials have acknowledged that the technological advances of recent years have led to irrevocable changes in the nature of trading and that the fast pace must be accepted. By adopting tighter controls, they say they hope to protect the interests of all market participants.

The German draft legislation “is deliberately arranged so that the Finance Ministry has the capability of making things more precise through provisions, and the stock markets are required by the law to be aware when the next trick from high-frequency traders pops up,” said a German government official who spoke anonymously on Tuesday.

While high-frequency trading firms are unlikely to welcome tighter rules, Deutsche Börse, the main German stock exchange, based in Frankfurt, said it would welcome the greater supervisory powers that regulators would have under the proposed law.

“It is good for all parties acting on the German financial market that we now have legal certainty how to deal with high-frequency traders,” the exchange said last week.

The European legislation under discussion, if approved in committee, is expected to become the basis for talks between representatives from the European Parliament and individual governments. Upon completion of that process, the draft measure would need the approval of the full European Parliament and all 27 of the European Union’s members before becoming law.

The legislation would seek even tighter controls on fast trading than the German proposal. Among the most closely scrutinized aspects of the European measure are rules aimed at limiting the ability of algorithm-driven trading to exaggerate volatility in financial markets.

Markus Ferber, the lawmaker appointed by the European Parliament to report on the proposal, has recommended including rules to slow trading by a half-second, require all trading venues to institute ways to halt trading immediately and make it more expensive for traders to cancel large volumes of orders.

Those rules were needed to “curb mere volumes brought by high-frequency trading” and “to restore genuinely liquid, orderly and fair markets,” said Benoît Lallemand, a senior research analyst at Finance Watch in Brussels. “Only such markets can serve the real economy.”

Mr. Lallemand said he expected the committee to approve Mr. Ferber’s recommendations on Wednesday. “The focus then should be that governments come up with an equally ambitious proposal,” he said, though he said the legislation still could be watered down.

Melissa Eddy reported from Berlin and James Kanter from Brussels. Jack Ewing contributed reporting from Frankfurt and Nathaniel Popper from New York.