From Traditional Floor Trading to Electronic High Frequency Trading (HFT) Market Implications and Regulatory Aspects Prof. Dr. Hans Peter Burghof

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1 From Traditional Floor Trading to Electronic High Frequency Trading (HFT) Market Implications and Regulatory Aspects Prof. Dr. Hans Peter Burghof Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen

2 HFT has fundamentally changed financial markets Traditional floor trading Modern high frequency trading (HFT) Amazon: More than 100,000 quotes per second in Amazon on June 7, 2013 BATS IPO from $15 to 0 in 1.5 seconds: Stock begins trading at $ Within 900 milliseconds from opening the stock price had fallen to $0.29. Within 1.5 seconds the price dropped to $ trades were executed before trading halt. May , Flash Crash: DJIA plunges by around 1,000 points (9%) and recovers the losses within minutes Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 2

3 in the sense that Today s market environment Human are removed from the direct decision making process of security transactions and substituted by computer software Speed has become the single most important factor in security trading Fundamentals do not play any role for most high frequency traders Holding periods are often limited to milliseconds (10 3 )or even nanoseconds (10 9 ) The competitive advantage has shifted from those with superior capabilities in determining the true value of an asset to those who can trade faster than others! Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 3

4 What is HFT? HFT is a subset of algorithmic trading Algorithmic Trading High Frequency Trading Definition of algorithmic trading in Mifid II: Trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention Typical features of HFT: Proprietary trading Large number of orders with small size Rapid cancellation of orders No overnight positions Very short holding periods Use of colocation and proximity services Focus on highly liquid securities Not only one type of HFT but a variety of different strategies Market making Statistical arbitrage Spread Capturing Market Neutral Rebate Driven Arbitrage Strategies Cross Arbitrage (Asset, Market, ETF) Strategies Liquidity detection Others Pinging Momentum Sniping Latency Arbitrage Quote Matching Manipulation (e.g. Quote Stuffing, Spoofing) Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 4

5 HFT activity 40% 35% 30% HFT activity at regulated markets and MTFs in Europe in 5/2013 Falling market shares of HFT (39% in Europe in 2012 according to TABB Group) Value traded 25% 20% 15% 10% 5% Generally higher market shares of HFT in the U.S. (51% in in 2012 according to TABB Group) 0% All Venues Borsa Italiana NYSE Euronext Amsterdam London Stock Exchange NYSE Euronext Paris NYSE Euronext Brussels HFT Activity NYSE Euronext Lisbon Irish Stock Exchange BATS CHI X Turquoise Higher market shares at less regulated trading venues HFT activity has plateaued on established markets, continues to expand globally (e.g. Asia) Source: European Securities and Markets Authority (2014): Report on Trends, Risks and Vulnerabilities Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 5

6 Market implications Market quality Authors Sample period Market Method Liquidity Volatility Brogaard et al. (2014) 08 10/ 2012 NASDAQ OMX Stockholm Empirical Price discovery Martinez, Rosu (2013) Theoretical Hasbrouck, Saar (2013) 10/ 2007 & 06/ 2008 NASDAQ Empirical Brogaard et al. (2012) End of year 2009 NASDAQ, BATS Empirical Bias et al. (2011) Theoretical Kirilenko et al. (2011) 06/ 2010 (Flash Crash) E mini S&P 500 Empirical Civitanic, Krilenko (2010) Theoretical Brogaard (2010) 2008,2009 & 02/ 2010 NASDAQ Empirical Overall, the literature tends to find that HFT improves market quality! Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 6

7 Market implications Market quality Influence of HFT on market quality Liquidity Volatility Price discovery Based on traditional liquidity measures HFT tends to increase liquidity on the market But: The duration of liquidity provision is often short HFT traders tend to reduce volatility due to smaller price differences depending on market conditions. But: This effect seems to affect predominantly short term volatility HFT traders act as market makers and hence can positively affect price discovery But: Depending on market situation and strategy HFT traders can also strongly deviate from that role The proponents of HFT argue that HFT plays an important role in the price discovery process, leading to an increase in price efficiency => improved market quality Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 7

8 Market implications Negative externalities The downside of HFT The need for speed harms real investments, market stability & fairness Speed has become the single most important factor in security trading Fundamentals do not play any role for most high frequency traders Operational risk: Quote stuffing Sunshine liquidity Sunshine marketmaking Systemic risk Flash crashes Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 8

9 Market implications Operational risk The strong growth of HFT activity during the past decade lead to a sharp increase in the amount of quotes Why is this a problem? The placement of bids and asks via HFT can be compared with sending spam s In relation to sending and receiving it is practically free of charge for the sender but not for the recipient Forwarding and processing continuously increasing amounts of data generates increasingly problems and costs for trading venues and market participants and may lead to a breakdown of the trading system of individual trading venues. HFT abuse the restricted capacity of trading venues and other market participants to handle continuously increasing data volumes: Speed wars aka quote stuffing aka fake liquidity Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 9

10 Market implications Operational risk Quote stuffing / fake liquidity War between HFT algorithms HFT place a large amount of quotes within a single second (e.g and more) and cancels it immediately Other market participants and trading venues have to process these quotes which takes time The HFT originator knows that his quotes are fake and neglects their processing. Yet, he analyses the reaction of the other market participants and waits for arbitrage opportunities when prices differ Quote stuffing is a main driver for system outages at trading venues Pure market manipulation! Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 10

11 Market implications Operational risk Source: Nanex Quote stuffing in Michal Kors Inc. (KORS) on Feb. 14, 2012 KORS is stuffed with quotes from multiple exchanges exceeding quotes/sec The picture shows about 40 seconds divided into 50 millisecond intervals Before KORS hand only a few hundred trades in the same time span Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 11

12 Market implications Operational risk Sunshine liquidity / Sunshine market making Burghof/Spankowski/Wagener (2014) find that trading activity on Multilateral Trading Facilities (MTFs) where HFT are preferably active reduces significantly in times of increased market distress. Also when market making becomes difficult, market participants on MTFs presumably HFT seem to reduce their liquidity provision. Hence, HFT is no big help for a sustainable efficiency in financial markets Source: Burghof/Spankowski/Wagener (2014): Back to the roots Market fragmentation and order routing Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 12

13 Market implications Systemic risk Flash crash on May 6, 2010 in the DOW Trigger: Negative news of Europe/Greek > new riots At 14:42:44:075 was an immediate sale of ~ $125 million worth of June 2010 emini futures and a sale of nearly $100 million ETFs HFT did not trigger the flash crash, but their responses to the selling pressure on that day increased volatility Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 13

14 Market implications Summary Critical in very volatile market situations Positive influence on market quality No real No fair market investments conditions for non HFT No clear cut result can be drawn Quote stuffing can reduce the quality of quotes and affect market quality negatively Improves price discovery Regulation? HFT HFT strategies Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 14

15 Regulatory aspects In general, European (MiFID) and German aspects on HFT regulation seem to be compatible, both foresee: Trading venue capacities have to be sufficient for HFT Excessive usage fees to be charged on all trading venues Order flagging to control HFT strategies ( > Trader ID) Order to Trade ratios published by all trading venues Installment of circuit breakers at all trading venues Appropriate minimum tick sizes on all trading venues German details: Stock Exchange Supervisory Authorities and BaFin receive increased enforcement powers (information requests, prohibition of Algo trading strategies) High Frequency Traders are now subject to licensing obligation under German Banking Act Regulation and supervision of HFT as financial services institutions by BaFin ( > Prop traders now also have to register) Regulation on the basis of taxes has been seen critical by several scholarly papers. Deterioration of market quality in France and Italy where this regulatory practice has been used (e.g., Meyer et al., 2013; Gomber et al., 2014) Universität Hohenheim Institut für Financial Management Lehrstuhl für Bankwirtschaft & Finanzdienstleistungen 15