Increased levels of high-frequency trading (HFT) may have actually dampened volatility in recent weeks rather than exacerbating it, according to market participants.
Market uncertainty in the first two weeks of August – triggered by government debt default concerns in Europe, as well as a downgrade of US government debt by Standard & Poor's – led to steep increases in price volatility and trading volumes. According to pan-European multilateral trading facility BATS Europe, trading turnover across Europe averaged €58.68 billion – including a peak day of €81.12 billion – in the first week of August and grew further to €69.56 billion the following week. In the last week of July trading in Europe averaged €37.06 billion per day. European volatility, as measured by the VSTOXX index, which reflects price fluctuations in EURO STOXX 50 options, reached a year-high of 49.85 on 9 August, more than double the levels seen in the last week of July.
Many commentators have claimed that increased activity by HFT firms may have contributed to volatility, but recent empirical evidence from Australia-based research consultancy Capital Markets Cooperative Research Centre (CMCRC) suggests the opposite is more likely. Based on recent studies of the Australian, French and Singaporean equities markets, Alex Frino, CEO, CMCRC, said HFT tends to stabilise markets during periods of market turmoil.
“Some HFT strategies pursue mean reversion strategies and try to profit from price volatility by riding a market dislocation until it reaches an equilibrium,” Frino told theTRADEnews.com. “We found HFT and volatility to be negatively correlated in French and Australian markets, which could be down to this type of activity.”
Kee-Meng Tan, the London-based head of Knight Capital's electronic trading group, an electronic market maker that doubled its trading activity on some days during the first two weeks of August, said HFT had had a calming effect.
“Electronic market makers absorbed a good part of the sell pressure during the recent turbulent markets and dampened volatility by bringing more liquidity into the market that helped to keep spreads tighter than they otherwise would have been,” he said. “If HFTs had reduced their participation in the market in the last couple of weeks, volatility would almost certainly have been higher.”
Richard Parsons, head of sales and trading at agency broker Instinet Europe, added that the large volume of messages and subsequent price changes created by all algorithmic orders – not just HFT – needs to be better understood by market participants.
“I think most high-frequency traders were responding to the volatility rather than causing it,” said Parsons. “There probably is a need for people to understand the confusion that can be caused by the sheer number of messages that automated trading generates, be it by buy-side firms or banks using their algos, or by HFT firms. However, the bottom line is that HFT did provide liquidity into the market.”
Parsons estimated that HFT accounted for between 60-70% of European liquidity in the first two weeks of August, compared to around 50% normally.
Increased HFT activity was also witnessed in the US, with consultancy TABB Group asserting that it accounted for 65% of equity trading in the first two weeks of August, from around 53% earlier in the year.
An opinion paper from US consultancy Woodbine Associates blamed the heightened volatility on a combination of regulation and technology, claiming that algorithms reacting to market conditions created a cycle that amplified fast-moving markets.
“We enjoy narrower spreads, generally speaking better executions, and more liquidity under normal market conditions at the expense of less equitable markets and greater volatility for short periods at times of stress,” read the paper.
HFT hazard
Anecdotal and research-based evidence in support of HFT stands in marked contrast to claims from some observers, including former UK financial services secretary Lord Paul Myners, that the high levels of volatility demanded a deeper probe into the practice.
“High-frequency trading appears so detached from the true function of capital markets, but is potentially fraught with hazard. It definitely deserves more attention than either [UK regulator] the Financial Services Authority or the Treasury has given it,” Myners was reported as saying.
A number of initiatives are already underway in Europe to better understand the role of HFT in the market.
In the MiFID II consultation document released earlier this year, the European Commission listed a number of proposals for curbing HFT activity, such as requiring high-frequency traders to continuously provide liquidity, minimum resting times for orders and a clearer definition of HFT activity.
Furthermore, pan-European securities regulator the European Securities and Markets Authority recently sent a questionnaire to over 150 market participants to help inform the MiFID review. The UK government is also conducting its own HFT investigation under the direction of its chief scientific adviser, Professor Sir John Beddington.
The UK study comprises two parts. The first is a lead expert group, which includes former London Stock Exchange (LSE) CEO Dame Clara Furse, now chairman of Nomura Holdings, Andy Haldane, executive director, financial stability at the Bank of England, and Kevin Houstoun, chairman of trading technology provider Rapid Addition and co-chair of FIX Protocol Limited's global technical committee. This expert group is conducting 24 separate academic studies on electronic trading and will be supported by further work from a stakeholder group that includes Kay Swinburne MEP, current LSE CEO Xavier Rolet and Mark Northwood, global head of trading at Fidelity International.