Tuesday, March 27, 2012

High Frequency Traders: Flash Crashers or Liquidity Providers?*

On 6 May 2010, major American stock indices and stock index futures nosedived by more than five percent before sharply recovering in less than 30 minutes. Since that infamous flash crash, high frequency traders (HFTs) have drawn the attention of regulators, exchanges and market participants, despite the fact that the crash was not triggered directly by HFTs, according to an official joint report released by the US CFTC and SEC. Nonetheless, fragmentation of trading venues and the establishment of the US Regulation National Market System and the European Union’s Markets in Financial Instruments Directive (MiFID) in 2007 requiring brokerages to find the best execution for customers, have led to the explosive growth of HFTs.

Some studies suggest that a few high-frequency trading (HFT) firms now account for more than 70 and 60 percent of overall trading volume on US equities and futures markets, respectively. HFTs’ share in European markets’ trading volume is estimated to be smaller than that of in US trading; however, they have continued to ramp up their activities on exchanges on both sides of the Atlantic.

High Frequency Trading in Energy Markets

According to CME’s algorithmic trading study (HFT is a subset of algorithmic trading) published on 15 July 2010, 35% of crude oil future trading and 71% of message traffic in the first quarter of 2010 came from algorithmic traders. Compared to other asset classes, algorithmic traders’ share in the volume of trade is still low, but in terms of message traffic, crude oil comes second after EuroFX futures. The CME report further suggests that increased algorithmic trading activity correlated with narrower bid/ask spreads, increased market depth and reduced volatility. That is to say, the presence of algorithmic traders substantially improved the quality of market. 

Although HFTs presence in futures markets has been on the rise, they are present in limited commodity markets, such as crude oil due to its higher liquidity. Some market participants argued that as more swaps activity shifts to electronic platforms, we should expect to see HFTs dominate in these markets. However, HFTs’ survival depends on the short time delays in trade execution. Therefore, HFTs’ arrival relies on the initial liquidity in the market place. That is to say, the survival or even arrival of HFTs onto swap execution facilities (SEFs) solely depends on the success of SEFs and liquidity in these platforms. As noted in the January OMR, the OTC market is different from the futures markets. Instruments (swaps) in the OTC markets can trade infrequently, often in significant sizes. Therefore, we would not expect to see an influx of order flows from HFTs to SEFs.

High Frequency Traders and Their Impacts

Regulators on both side of the Atlantic, while urging new curbs on high frequency trading, are still debating its definition. The Securities and Exchange Commission refers to them as “professional traders acting in a proprietary capacity that engage in strategies that generate a large number of trades on a daily basis. These traders could be organized in a variety of ways, including as a proprietary trading firm. Other characteristics often attributed to proprietary firms engaged in HFT are: (1) the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders; (2) use of co-location services and individual data feeds offered by exchanges and others to minimize network and other types of latencies; (3) very short time-frames for establishing and liquidating positions; (4) the submission of numerous orders that are cancelled shortly after submission; and (5) ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions over-night).” However, the term is still relatively new and there is no consensus yet on the definition of HFT. For example, the US CFTC announced in late January 2012 that it is forming a subcommittee that would be tasked with defining and identifying HFTs trading pattern and its possible impact on futures, swaps and options markets.

HFTs use several different strategies to enter the market. Some HFTs can be considered market makers, where they place buy and sell orders continuously throughout the trading day in order to earn bid and ask spreads. Some other HFTs can act as arbitrageurs to make profit from price discrepancies in certain assets trading simultaneously on separate markets. Most studies found that HFTs add substantially to the price discovery process, as well as eliminating any price differential across trading venues. Furthermore, it is argued that the arrival of HFTs and increased low-latency activity, defined as “strategies that respond to market events in the millisecond environment”, substantially improved the quality of markets by adding liquidity, lowering the trading costs (narrowing bid and ask spread), reducing short-term volatility and increasing the limit order book depth during normal and heightened uncertain times.

However, some studies suggested that without mandatory obligations to provide liquidity, HFTs may have exacerbated volatility by withdrawing liquidity from the market, especially during severe market episodes such as those experienced during the flash crash. Others also question the liquidity provided by HFTs. Since more than 95% of orders placed by the HFTs are cancelled immediately, some market participants are sceptical that high frequency trading provides liquidity to the markets. Some argue that HFTs provide liquidity when it is not needed. Others further argued that HFTs exhibit trading patterns inconsistent with the traditional definition of market making, in the sense that they aggressively trade in the direction of a price change that does not result in inventory accumulation.

As high frequency trading is becoming increasingly popular, concerns over trading practices and their impact on the quality and volatility of markets have been raised by some regulators and exchanges. For example, US CFTC Commissioner Chilton urges creating a registration category for high-frequency trading firms and imposing new restrictions on their trading practices if necessary. In the meantime, some exchanges in the US and Europe already took some steps by introducing penalties on high-frequency traders who place and cancel large number of bids and offers within milliseconds. Some regulators refer to such practices as parasitic trading. Others however, see HFT simply as a logical and inevitable upshot of both increases in risk‑hedging appetite and advances in information technology.

*IEA Oil Market Report-March 2012

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