Hedge Fund Arms Race

Date: Monday, April 27, 2009
Author: Floyd Norris, Blogs.nytimes.com

Rick Bookstaber, my favorite quant — and one who warned of the havoc his fellow quants were about to unleash on the world in his book, “A Demon of Our Own Design” — has an interesting blog post on what’s hot in hedge-fund land.

It is something called high-frequency trading, and seems to rely on executing trades faster than anyone else. If you get in first, you can be in the position to sell to the people who are running other strategies. Or something like that.

High-frequency trading did well because it thrives in an environment of high volatility and demand for liquidity, and 2008 was a hothouse for both. Every year, people pile on to whatever strategy did well the previous year — this tendency is worth a book or two on its own — and so this year high frequency is destined to be the darling of the fund of funds.

But I think the days for high-frequency trading are numbered. For one thing, high-frequency trading is capacity-constrained like few other strategies. The high-frequency trader is basically a stand-alone market maker; he is sitting there to provide liquidity to others. And one way he provides it is to pull in the positions that others will shortly be demanding — thus the need for speed. If the footprint for high-frequency traders gets too large, they become liquidity demanders themselves, and the jig is up.

If he is right on that forecast, then it may be worth noting that it is the high-frequency traders who provide the demand for the latest and fastest computer chips, such as Intel’s latest. Mr. Bookstaber says the race for computers that will execute trades a millisecond or two faster is an arms race. “The result is a cycle of spending which leaves everyone in the same relative position, only poorer.”

He thinks the quants should negotiate an arms-control treaty, and questions whether there is any benefit to society from getting some tiny increases in speed.

Such an accord probably will not come about, for which Intel should be grateful. But it might suffer anyway if the people who think they need such speed stop being stars.