Getting a grip on HFT liquidity

The new version of MiFID will constrain the way high-frequency traders are able to interact with the market, but the proposals could have the opposite effect of regulatory intentions.
By None

The European Commission wants to impose market making responsibilities on high-frequency traders. Is that all that MiFID II will ask of them?

In its MiFID II consultation document, the European Commission (EC) proposed limiting the flexibility of high-frequency traders, either by imposing a minimum resting period before an order can be adjusted or ensuring that the order-to-cancel ratio does not exceed a pre-specified level.

High-frequency trading (HFT) firms are not currently subject to any restrictions or obligations relating to the liquidity they provide in the European markets.

What would these proposals mean for high-frequency traders?

In both cases, the EC is aiming to make the liquidity high-frequency traders offer more solid.

One of the perceived benefits of HFT is that it offers short-term liquidity to the wider market. However, some institutions have claimed that this liquidity can be ephemeral, disappearing as soon as they try to trade against it. The EC intends to increase the ”executability' of this liquidity.

But some suggest the new rules could have the opposite effect. High-frequency traders update orders to ensure their strategies remain profitable and the bids and offers they quote stay fresh. If their activity is restrained, HFT firms may mitigate the associated risks by quoting wider spreads or paring back their activity.

Which of the two options would be more onerous?

It is most likely to be the minimum resting period. If high-frequency traders have to maintain a quote for a specific period of time, there is a risk of an adverse price movement during this period, which would lead to losses. Furthermore, the quoted spread is in danger of becoming stale, which could reduce the quality of price formation and potentially lead to more off-exchange trading.

With an order-to-cancel ratio limit, HFT firms could simply respond by reducing the amount they trade, which would make their strategies less profitable, but incur less risk.

This all sounds a bit drastic, what's the EC worried about?

The EC's proposals would help combat against such abusive practices like layering or spoofing, where traders send orders priced closely to the best bid or offer with no intention of executing, to increase the perceived liquidity in a stock.

The EC's automated trading proposals – of which its plans for HFT is one part – are also a response to the US ”flash crash' on 6 May, which sent markets spiraling for a short period.

While a subsequent report into the event did not find high-frequency traders to be a direct cause of the crash, it did mention a “hot potato” effect as high-frequency traders passed futures contracts back and forth to each other.

How did the US respond? Are there any other ways of constraining HFT activity?

In a meeting of a joint Securities and Exchange Commission and Commodity Futures Trading Commission advisory committee at the end of last week on the flash crash, the idea of charging for order cancellations was mooted. However, given the amount of reforms both regulators currently have on their plate, any possible proposals could be some way off.

In Canada, national regulator the Investment Industry Regulatory Organization of Canada (IIROC) is considering whether to introduce a fee model that would charge market participants per message, rather than per order.

IIROC's says this will help to align the fees they charge with the order surveillance costs they incur. The proposal will be decided on by Q2 this year and would likely reduce the profitability of HFT strategies, with some observers noting that high-frequency traders could reduce their market participation by 20%.

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