High Frequency Trading Background and Current Regulatory Discussion

Transcription

1 2. DVFA Banken Forum Frankfurt 20. Juni 2012 High Frequency Trading Background and Current Regulatory Discussion Prof. Dr. Peter Gomber Chair of Business Administration, especially e-finance E-Finance Lab University of Frankfurt

2 High Frequency Trading - Structure e F inance 1 Changes in Securities Trading due to new Trading Technologies 2 Algorithmic Trading and High Frequency Trading - Definition, Strategies and Delineation - 3 Current Regulatory Discussion

3 High Frequency Trading - Structure e F inance 1 Changes in Securities Trading due to new Trading Technologies 2 Algorithmic Trading and High Frequency Trading - Definition, Strategies and Delineation - 3 Current Regulatory Discussion

4 The value chain in securities trading e F inance Investors (Buy-Side) Market Access Intermediaries (Sell-Side) Market Infrastructure Providers Retail Investors Institutional Investors Investment Fund Company Broker- Dealer Broker- Dealer Securities markets Clearing Settlement Custody trade processes post trade processes

5 The value chain in securities trading e F inance Investors (Buy-Side) Market Access Intermediaries (Sell-Side) Market Infrastructure Providers Investment Fund Company High Frequency Trading Broker- Dealer Securities markets Algorithmic Trading trade processes post trade processes

6 Technology walks up the value chain and supports an ever increasing range of former human trading behaviors Exchange Exchange Exchange Sell Side Sell Side Sell Side Buy Side Buy Side Buy Side Electronification of major markets Begin of success story of e-clob Successive volume shift and shut down of floors Electronic eyes Quote machines Technical support for liquidity providers to fulfill their duties in the electronic order book Establishment of Buy Side electronic desks with DMA tools Introduction of OMS with FIX connectivity First Algos used by Sell Side desks ~1990 ~1995 ~2000 e F inance

7 Technology walks up the value chain and supports an ever increasing range of former human trading behaviors Exchange Sell Side Buy Side Algorithmic Trading offered to Buy Side Smart Order Routing Systems specifically in the US equity markets ~2003 e F inance Exchange HFT Sell Side Buy Side Latency becomes key competitive factor Proximity services to overcome latency The term High Frequency Trading emerges ~2006 Exchange HFT Sell Side Buy Side Boundaries between buy side and sell side and between market providers and sell side are getting blurred US flash crash on May, Increased regulatory scrutiny on HFT ~ 2010

8 High Frequency Trading - Structure e F inance 1 Changes in Securities Trading due to new Trading Technologies 2 Algorithmic Trading and High Frequency Trading - Definition, Strategies and Delineation - 3 Current Regulatory Discussion

9 Algorithmic Trading e F inance Buy Side institutional Broker Algorithmic trading is - a trading service - that enables order submissions - without human intervention based on predefined quantitative models Historical Data Quantitative Models Algorithmic Trading Engine Real-time Data The algorithms determine the splitting and timing of orders on the basis of predefined parameters using historic and real-time market data. Algorithmic trading is referred to both a proprietary trading tool of brokers ECNs MTFs Exchanges and a service provided to buy-side customers by brokers.

10 High Frequency Trading versus Algorithmic Trading high Execution Latency low High Frequency Trading Traditional long-term investing Algorithmic or electronic trading (execution) short Position holding period long Source: Aldrige (2010)

11 Delineating Algorithmic Trading and High Frequency Trading Common for HFT and AT 1) Pre-designed trading decisions 2) Used by professional traders 3) Observing market data in real-time 4) Automated order submission 5) Automated order management 6) Without human intervention 7) Use of direct market access Specific for AT excluding HFT 1) Agent trading 2) Minimize market impact (for large orders) 3) Goal is to achieve a particular benchmark 4) Holding periods possibly days/weeks/months 5) Working an order through time and across markets Specific for HFT 1) Very high number of orders 2) Rapid order cancellation 3) Proprietary trading 4) Profit from buying and selling (as middleman) 5) No significant position at end of day (flat position) 6) Very short holding periods 7) Extracting very low margins per trade 8) Low latency requirement 9) Use of co-location/proximity and individual data feeds 10) Focus on high liquid instruments Gomber et al. (2011)

12 High Frequency Trading has become an important factor in trading on international markets HFT Market shares from industry and academic studies e F inance Origin Date of US Europe Australia publication TABB Group Sep-09 61% Celent Dec-09 42% of US Rapidly growing trade volume Rosenblatt Securities Sep-09 66% ~35% and growing fast Broogard Nov-10 68% of Nasdaq trade volume Jarnecic and Snape Jun-10 20% and 32% of LSE total trades and 19% and 28% of total volume Tradeworx Apr-10 40% ASX Feb-10 10% of ASX trade volume Swinburne Nov-10 70% 40% TABB Group Jan-11 35% of overall UK market and 77% of turnover in continuous markets Gomber et al. (2011)

13 Evolution of Algorithmic Trading Stratgies e F inance 1st generation: 2nd generation: 3rd generation: 4th generation: Market-centric benchmarks Ordercentric benchmarks Adaptive to market endogenous information Adaptive to market exogenous information Gomber et al. (2011)

14 Algorithmic trading: Key first generation algorithms and strategies e F inance Key algorithms Benchmark: price Benchmark: volume Benchmark: trading period Benchmark: (implicit) trading costs VWAP (volume weighted average price) TWAP (time weighted average price) Participation rates, TVOL (target volume) / VOL INLINE Market at open Market at close Spread costs Market impact Implementation shortfall / Arrival Price

15 High Frequency Trading: Key strategies High Frequency Based Strategies Electronic Liquidity Provision (Statistical) Arbitrage Liquidity Detection Others Spread Capturing Market Neutral Arbitrage Sniffing/ Pinging/ Sniping Latency Arbitrage Rebate Driven strategies Cross Asset, Cross Market & ETF Arbitrage Quote Matching / Layering / Quote Stuffing Short Term Momentum Gomber et al. (2011)

16 High Speed Trading is Like Shooting at Fast Moving Targets Business is fueled by fast changing information Latency is an obstacle when reacting to changing conditions This can be compared to a an archer where not only the bulls eye is moving...but the whole target will be deformed Changes in the market situation during the latency lag impose a gamble on the trader Ende et al. (2011)

17 The value of low latency Latency is not a question of absolute speed It is a question of execution certainty and therefore transfers into a significant risk component in trading if traders underperform in speed relative to other traders Automated Trader (2006)

18 The value of low latency Latency is not a question of absolute speed It is a question of execution certainty and therefore transfers into a significant risk component in trading if traders underperform in speed relative to other traders Current actual orderbook situation t 0 -Book Bid Ask Continuous trading t 2 -Book Bid Ask Continuous trading Perceived orderbook situation Investor A t 0 -Book Bid Ask trading decision: Buy t 0 -Book Order no longer executable! Trading decision: Buy Limit Bid Ask Investor B Low latency High latency t 0 t 1 t 2 t 3 time

19 The old and the new trading floors exchange exchange Equity trading The new floor traders traders Equity trading The old floor

20 High Frequency Trading - Structure 1 Changes in Securities Trading due to new Trading Technologies 2 Algorithmic Trading and High Frequency Trading - Definition, Strategies and Delineation - 3 Current Regulatory Discussion

21 Assessment of the role of trading technology in financial markets by the European Commission Draft MiFID II (recital 46): The use of trading technology has increased the speed, capacity and complexity of how investors trade. [ ] Trading technology has provided benefits to the market and market participants generally such as wider participation in markets, increased liquidity, narrower spreads, reduced short term volatility and the means to obtain better execution of orders for clients. Yet, it also gives rise to a number of potential risks such as increased risk of overloading systems of trading venues due to large volumes of orders, risks of algorithmic trading generating duplicative or erroneous orders or otherwise malfunctioning in a way that may create a disorderly market risk of algorithmic trading systems overreacting to other market events which can exacerbate volatility if there is a pre-existing market problem. Finally, algo/high frequency trading can lend itself to forms of abusive behaviour if misused. (European Commission, 2011)

22 Introduction of a definition of Algorithmic Trading / HFT in Art. 4 MiFID Draft MiFID II (Art. 4 par. 2 (30)): "Algorithmic trading" means 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. Draft MiFID II (recital 44): A specific subset of algorithmic trading is high frequency trading where a trading system analyses data or signals from the market at high speed and then sends or updates large numbers of orders within a very short time period in response to that analysis. High frequency trading is typically done by the traders using their own capital to trade and rather than being a strategy in itself is usually the use of sophisticated technology to implement more traditional trading strategies such as market making or arbitrage. (European Commission, 2011)

23 Proposals for Algo Trading / HFT (I) - MiFID II scope - Bringing Algo Trading / HFT under the scope of MiFID In MIFID I set-up, even if an Algo Trader / HFT is involved in significant amount of trading, he may not be subject to MiFID requirements and supervision by a CA due to exceptions in MiFID I (Art. 2, par. 1 (d)) on licensing for dealing on own account Proposal of the EC in Draft MiFID II (Art. 2, par. 1 (d)) : This Directive shall not apply to:. (d) persons who do not provide any investment services or activities other than dealing on own account unless they: (i) are market makers (ii) are a member of or a participant in a regulated market or MTF; or (iii) deal on own account by executing client orders In contrary to public consultation (October, 2010), no specified minimum quantitative threshold is applied

24 Proposals for Algo Trading / HFT (II) - Organisational requirements for investment firms - New specific organisational requirements introduced in MiFID II (Art. 17) for investment firms : Effective systems and risk controls to ensure that trading systems are resilient and have sufficient capacity are subject to appropriate trading thresholds and limits prevent the sending of erroneous orders prevent the system otherwise functioning in a way that may create or contribute to a disorderly market Information provision to competent authority (at least annually) on description of the nature of its algorithmic trading strategies details of the trading parameters or limits to which the system is subject key compliance and risk controls that it has in place details of the testing of its systems Liquidity provision i. e. Algorithmic trading strategy shall be in continuous operation during the trading hours of the trading venue to which it sends orders or through the systems of which it executes transactions ensure that the strategy posts firm quotes at competitive prices with the result of providing liquidity on a regular and ongoing basis to these trading venues at all times, regardless of prevailing market conditions

25 Proposals for Algo Trading / HFT (III) - Organisational requirements for trading venues - New specific organisational requirements introduced in MiFID II (Art. 19, 20, 51) require trading venues to have in place effective systems, procedures and arrangements to ensure System resiliency, i.e. its trading systems have sufficient capacity to deal with peak order and message volumes, are able to ensure orderly trading under conditions of market stress, are fully tested to ensure such conditions are met and are subject to effective business continuity arrangements Adequate handling of errors and of extreme price movements, i.e. reject orders that exceed pre-determined volume and price thresholds reject orders that are clearly erroneous and to be able to temporarily halt trading if there is a significant price movement on that market or a related market during a short period and in exceptional cases, to be able to cancel, vary or correct any transaction Adequate handling of electronic trading systems, i.e. that Algo systems cannot create or contribute to disorderly trading conditions to have systems to limit the ratio of unexecuted orders to transactions being able to slow down the order flow if system capacity might be reached to be able to limit the minimum tick size on the market rules on co-location and fee structures to be transparent, fair and non-discriminatory.

26 EU Parliament s March 2012 First Reading Key Amendment Proposals Algo / HFT HFT explicit definition: trading at speeds where the physical latency of the mechanism for transmitting, cancelling or modifying orders becomes the determining factor in the time taken to communicate the instruction to a trading venue or to execute a transaction; HFT-strategies' explicit definition based on four of these characteristics: (i) it uses co-location facilities; (ii) it relates to a daily portfolio turnover of at least 50 %; (iii) the ratio of orders to trades exceeds 4:1 (iv) the proportion of orders cancelled exceeds 20 %; (v) the majority of positions taken are unwound within the same day; (vi) over 50 % of the orders or transactions are made on trading venues offering discounts or rebates to orders which provide liquidity are eligible for such rebates; Liquidity provision requirement only for firms that engage in high-frequency trading strategies Regulated markets to have effective systems, procedures and arrangements in place to ensure that all orders entered into the system by a member or participant are valid for a minimum of 500 milliseconds. Regulated markets to impose a higher fee for placing an order that is subsequently cancelled than an order which is executed and higher fee on participants placing a high ratio of cancelled orders to executed. Regulated Market allowed to adjust its fees for cancelled orders according to the length of time for which the order was maintained. Fee structures should not create incentives for disorderly trading conditions or market abuse. End the practice of direct electronic access to ensure that market participants can be identified and held accountable for any disorderly conditions for which they are responsible.

27 While MiFID II while not have to be applied before 2014, ESMA Guidelines on HFT are applicable since May, 2012 Guidelines: Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities Guideline 1 and 2 Organisational requirements (OrgReq) for regulated markets, multilateral trading facilities and investment firms electronic trading systems (including trading algorithms) Guideline 3 and 4 OrgReq for regulated markets, multilateral trading facilities and investment firms to promote fair and orderly trading in an automated trading environment Guideline 5 and 6 OrgReq for regulated markets, multilateral trading facilities and investment firms to prevent market abuse (in particular market manipulation) in an automated trading environment Guideline 7 and 8 OrgReq for regulated markets and multilateral trading facilities whose members/participants and users provide direct market access/sponsored access and OrgReq for investment firms that provide direct market access and/or sponsored access

28 A look into the future of Electronic Trading The front office of the future will have only two employees, a man and a dog. The man will be there to feed the dog. The dog will be there to keep the man from touching the equipment 28

29 Thanks a lot!! Peter Gomber Professur für Betriebswirtschaftslehre, insbesondere e-finance Grüneburgplatz Frankfurt Tel.: +49 (0) Fax: +49 (0)