In the US, concerns that high-frequency trading (HFT) is damaging the ”fair and orderly market' that the Securities and Exchanges Commission (SEC) is pledged to maintain have risen steadily since February 2009. But in the 18-plus months since research group Aite estimated HFT at 70% of US equity market volume, no one has been able to lay the blame for significant market failings squarely at the door of high-frequency traders.
Despite their presence in the US equity market for around a decade, the cash flow and business models of HFT firms are still an unknown quantity to regulators and other market participants. In recent years, financial innovations – from new products such as collateralised debt obligations to advanced trading practices such as execution algorithms – have triggered market crashes, both major and minor. The suggestion that HFT could trigger a similar event is based on the experience that the speed of innovation can change markets more rapidly than either regulators or market participants can keep pace with. To slow it down, politicians and regulators are considering ways to curb the current level of HFT activity. A simple way of doing so would be to impose limits or costs on trade cancellation.
Currently some 90% of HFT orders are said to be cancelled before they have the chance to be executed. The placing of many thousands of orders, with no intention to follow through on them, is considered misleading by some other participants. Buy-side firms may move to sell 1,000 shares seeing sufficient buy orders in the market, only to find the orders disappear after just 100 shares have sold. Some would consider this an example of false quotes being placed to elicit the size of an order.
High levels of cancellations are not necessarily intended to deceive however. Because HFT strategies typically rely upon large volumes of orders providing a small profit margin from incremental price movements, high levels of cancels are implicitly required to manage associated risk. Given that the majority of stock exchanges operate on a price-time priority basis, HFT firms would say that if their orders are placed too late in a queue, they cannot be guaranteed to be filled before the price moves. In these circumstances they want to have the ability to cancel the order.
There is a case to answer that cancellation is sometimes used less nobly. ”Quote stuffing', the practice whereby a market participant places large amounts of quotes on a single stock in a very short space of time, was identified in a recent report on the 6 May ”flash crash' by data vendor Nanex as forcing the IT systems of HFT firms to process high numbers of quotes, thereby slowing their systems fractionally. In this case, the initiator's systems can ignore the quotes, knowing they will be cancelled, and can therefore operate at a faster speed than its rivals, increasing its chances of trading at optimal the price. The evidence for this activity occurring is fairly solid. Nanex has some graphical representations of the patterns that look as natural as crop circles.
Unless it can be proved that a particular trading strategy is intended to manipulate a price, there no case for outlawing it. But if market participants are acting in a way that could be perceived as weakening investor confidence, and large scale order cancellation may fall into that category, regulators could easily seek to impose fees or limits on their practices. If such a levy were put upon HFT firms, it would hamstring their business models. The risk to the wider market could be that reducing the number of viable HFT strategy reduces the liquidity available for all.
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