Cheaper, faster, smarter

This feature originally appeared in the December 2009 edition of AsianInvestor magazine. To subscribe to our premium content, please email Stephen Tang or call +852 2122 5239.

High-frequency trading is coming to Asian stock markets. It has come to account for 70% of volumes on US stock exchanges. Ample liquidity is one condition for HFT, which in turn creates more liquidity, and thereby induces exchanges and other alternative venues to narrow spreads and reduce costs.

But the proliferation of HFT strategies has also caused alarm among Asian exchange officials and regulators about whether it is also a source of instability and can allow for unfair advantages.

A misperception about HFT is that it is all about speed of trading. Not so, says Hani Shalabi, director of advanced execution services at Credit Suisse in Hong Kong. Shalabi defines a HFT client as "a high frequency consumer of data and a high frequency decision maker". He spoke at a recent seminar organized by Thomson Reuters.

Speed is however an important component to most HFT strategies, and is therefore achievable only via computers, without regard to fundamental views on stocks.

Wesley Hu, partner and CIO at Hong Kong fund of hedge funds Gen2 Partners, says HFT is of increasing interest to hedge funds because its results are not correlated to beta long-only asset classes. "It's a low-margin, high-volume business in which liquidity is key," he says.

Hand in hand with this is the necessity for low costs, because each trade's expected margin is thin. Another characteristic of HFT is that positions are held for a short time - within one day.

Liquidity and low costs are not the hallmarks of Asian stock exchanges. So why do market participants see more high-frequency traders becoming active here?

The impending debut of the Arrowhead system at the Tokyo Stock Exchange is but one example of how the region's venues are changing their rules and improving their technology, in order to boost their speed and latency. This is helping to narrow spreads and attract more market participants.

Post Lehman, hedge funds are looking for new ways to add alpha. HFT offers a higher Sharpe ratio, no correlation to the broad market index, stable returns and no overnight risk to counterparties or market movements.

HFT is not a magic bullet, as volatility comes with its own swings and cycles; during periods such as early 2009 when volatility vanished, HFT strategies were stuck in the doldrums. But in liquid markets returns are stable enough to serve as a control or a buffer for when hedge funds' other strategies don't fare well.