Chicago's Essex Radez, a self-clearing broker-dealer specializing in high-speed algorithmic trading, has slashed operating costs, such as what it pays for market data and the clearing of transactions, to a bare minimum.

But lower volatility and trade volumes are biting into profits. That trend over the last six months conflicts precariously with competitive needs for custom technology to speed up orders and for capital to pursue trading involving longer-term positions, prompting the firm to consider mergers or partnerships.

Lower profits mixed with the ever-pressing need among trading shops relying on faster and more sophisticated technology to outdo competitors has already prompted a trickle of mergers and acquisitions that some anticipate turning into a steady stream, if not a flood.

John Muehlhausen, chief technology officer at Essex, says the proprietary trading firm became a self-clearing broker-dealer in 2004, to cut out the fee it paid to a correspondent clearing house. Since clearers tend to pass along the cost of trade-related technology, asset custody and other services, their clearing fees tend to be high compared to Essex's costs to self-clear, after it peels away unnecessary services.

"We clear all of our business with a couple of computers, some software we wrote, and a very small staff," Muehlhausen says.

Essex's streamlined clearing costs amount to little more than the Depository Trust & Clearing Corp.'s small per-trade settlement fee that all self-clearing broker-dealers pay or pass on to customers as a part of the clearing process, he said. DTCC says it charges its members an average of three-tenths of a cent per transaction.

The firm also developed its own low-latency market-data subsidiary that connects directly to the major exchanges' data centers and ECNs. Essex defrays its costs by charging modest market data fees to its customers. "We think that unless you trade for practically nothing, it's going to be hard to make any money," Muehlhausen says, adding Essex provides a "near-zero cost basis" for automated equity traders.

In addition to trading for its own account, Essex houses a few dozen clients that trade independently through the firm. The need to cut costs has been exacerbated by the plunge in price volatility and trade volumes-the fuel driving many active-trading strategies-over the last six months.

The Chicago Board Options Exchange Volatility Index has plunged to under 18 this year from above 80 at the peak of the credit shock in October 2008. That's reduced the securities price discrepancies and high volumes many high-frequency trading strategies require to capture tiny profits per trade.

Self-clearing and generating market data take significant time and resources to implement, which leads HFT firms-and especially exchange members catering to HFT traders-to increasingly consider consolidation.

"The consolidation is really to spread fixed costs over a broader base" of trading activity, says Bruce Mumford, who heads up Mumford Capital Services, a Chicago-based consultancy that advised trading firms in recent mergers.

Mumford advised two Chicago-headquartered proprietary shops trading futures, fixed-income, options and currencies-GH Traders and Harrison Trading Group-last summer when they united to form HTG Capital, headquartered in Chicago. Mumford also advised HTG in its December acquisition of Chicago-based Kingstree Trading's equity index and energy trading groups, which brought additional trading activity under its roof.

William McNeill, CEO of HTG, says Harrison Trading and GH Traders had each given up their broker-dealer licenses in early 2009 because the broker-dealers compliance costs outweighed their earnings, and the firms focused on futures and options where they saw profit potential.

McNeill says that in addition to a "crummy" year for trading due to low volatility and trade volume, technology costs are driving decisions. "As far as equipment goes, if it's in your office more than 18 months, it's probably obsolete," McNeill says.

McNeil points first to infrastructure costs, saying his firm spends $60,000 a month to connect to and co-locate servers near the major exchanges in New York and Chicago, and says that high-frequency firms can easily spend $100,000 monthly on those services. HTG also supports an in-house technology staff comprising three full-time programmers and three hybrid programmer/traders.

They've developed software to execute trades as well as middleware, to manage connections with different exchanges, evaluate risks, and route orders to the most advantageous venues.

McNeil says it's no longer sufficient for traders to rely on instincts and enter orders by pointing and clicking on a trading screen. HTG has developed tools enabling traders to feed their strategies into HTG's platform and have it automate their orders, so executions can be made in milliseconds or less-what McNeil refers to as a "gray box." Broadening its revenue base through mergers and acquisitions helps support the development of HTG's technology, and so should shifting to a more automated business model. Greater execution volumes will also push HTG into lower execution-fee tiers at the exchanges.

Today, HTG's traders retain a majority of their profits, but when gray-box trading approaches 50% of the firm's revenue-tripling the current percentage-the company itself will retain the majority of profits. That, McNeil says, is because at that point its technology will be driving profits and not the traders.

"When you invent the tools and give them to the trader, at some point it's your technology that's making the money and less the trader. Your business model has changed," McNeil says.

Mumford says the futures "arcades"-the screen-based trading systems that require traders to manually point and click to send out orders-began consolidating in late 2007. Chicago's Traditum Group, for example, was formed from the merger of Darwin Capital, Federal Trading, and Gambit Trading in late 2007. On Jan. 20, Infinium Capital Management, a derivatives proprietary trading shop, announced a merger with Fox River Partners, which specializes in equity options. Mumford says his firm has worked on numerous bids in recent months, some supporting firm mergers and others acquisitions of units.

He adds the arcades typically have given traders 50% of profits and seasoned ones as much as 80% to keep them at the shop, but they still risked seeing traders hop to competitors.

Now, high-frequency firms want to retain intellectual capital and are looking to hire "quants," for salaries and discretionary bonuses, to build proprietary algorithmic models that the firm owns, so they avoid seeing the assets that generate revenue walk out the door.

Stephen Ehrlich, CEO of securities-focused Lightspeed Trading, formed by a 2006 management buyout of eTrade Financial's proprietary trading business, sees less consolidation among the high-frequency traders themselves than the exchange members that service them. Lightspeed has already made several acquisitions, including Schonfeld Holding's active trader unit in early 2007 and direct-market-access broker Integrity Trading in January 2008.

Ehrlich says that lower trading volume has been especially hard on smaller competitors. "So this may be an acquisition opportunity for us," Ehrlich says, adding, "We have infrastructure that handles four or five times our current volume."

Ehrlich describes a maturation process for active trading in equities that echoes futures.

"Ten years ago it was web-based traders that relied on their brokers to make routing decisions. The next stage was DMA (direct market access) platforms like Lightspeed's. And the next stage is to automate fully," Ehrlich says, adding that traders moving to DMA from relying on brokers is still in progress. So the step toward full automation holds significant opportunity for firms who can provide that technology.

This article can also be found at SecuritiesIndustry.com.

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