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High Frequency Trading and the "Liquidity Mirage"
There has been a flurry of interest in recent blog post by Dobrislav Dobrev and Ernst Schaumburg, economists with the Federal Reserve Bank of New York, which suggests that high-frequency trading (“HFT”) in U.S. Treasury markets results in liquidity levels that appear deeper than they actually seem. The blog terms this situation the “liquidity mirage”. This blog follows concerns around the U.S. Treasury market, a $12.7 trillion sector, in the wake of the 15 October 2014 "flash" rally, when U.S. Treasuries registered extreme volatility in their yield in under an hour.
However, this blog is just the latest round in a longer-standing argument between proponents of HFT, who claim that it has helped to enhance market liquidity and narrow the bid-ask spread, and those who believe that whatever liquidity HFT creates is superficial because the investments are held for seconds or fractions of a second before being sold back again, potentially back and forth between high-frequency traders, until they are bought by an investor. Opponents say there is thus no ultimate creation of liquidity.
Liquidity can be described as the depth of market to absorb buy and sell interest of even large orders at prices appropriate to supply and demand on a timely basis. When liquidity is high, investors can successfully trade a large order close to the current price and within a short time period.
What is HFT?
HFT is a legitimate trading strategy that is generally viewed as a subset of algorithmic trading. It operates in practice where a trading system analyses data or signals from the market at high speed and then sends or updates large numbers of orders, quotes and cancellations within a very short time period in response to that analysis.
One feature of this type of trading is that it can operate with no human input to the decision making process, beyond setting certain parameters of an underlying algorithm. Other characteristics of HFT include a short time-frame for establishing and liquidating positions, high daily portfolio turnover and a high intraday order-to-trade ratio.
HFT is often utilised by traders using their own capital to trade and rather than being a particular strategy in itself, is usually just the use of sophisticated technology to implement more traditional trading strategies such as market making or arbitrage.
New regulation of HFT
In Europe, Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (“MiFID II”) entered into force on 2 July 2014 and will apply from 3 January 2017. Part of MiFID II seeks to introduce rules and guidelines to mitigate against potential “flash crashes” caused or exacerbated by automated trading technology and HFT.
The European Commission recognises in the recitals to MiFID II in the context of HFT that 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”. However, MiFID II highlights some issues arguably created by technological advances, such as the increased risk of overloading trading venue’s systems and the risk of algorithmic trading, such as HFT, generating erroneous orders or otherwise malfunctioning in a way that may create a disorderly market. In order to counter these potential issues MiFID II imposes a number of new requirements.
MiFID II will require an HFT firm that pursues a “market making strategy” to:
- carry on its market making activity continuously during a specified proportion of the trading venue’s trading day, except under exceptional circumstance
- enter into a written agreement with the trading venue stating their market making obligations; and
- have in place effective systems and controls to ensure that it fulfils its obligations under the agreement.
A firm will be deemed to be pursuing a “market making strategy” where as a member of a trading venue its strategy when dealing on its own account involves:
- posting firm, simultaneous two way quotes of comparable size and at competitive prices,
- that relate to one or more financial instruments,
- on single or multiple trading venues,
- on a regular and frequent basis.
MiFID II dictates that most firms that engage in a HFT strategy will have to become regulated by their national competent authority. In the UK this will be the Financial Conduct Authority (“FCA”).
HFT firms will be further required to store time records in relation to their use of algorithms in their trading operations for an extended period. The European Securities and Markets Authority (“ESMA”) has suggested that HFT firms should keep accurate and time sequenced records of all its placed orders, including cancellations of orders, executed orders and quotations on trading venues, details of algorithms and all key compliance and risk controls. These details should be made available to the national competent authority upon request and should be held for a period of 5 years.
Trading venues will also be required to install ‘circuit breakers’ into their systems so that they can temporarily halt trading or constrain it if there are sudden unexpected price movements. A tick size regime in financial instruments will also have to be introduced and calibrated to reflect the liquidity profile of the financial instrument and the average bid-ask spread. It will be down to each Member State to balance the desirability of stabilising prices with the need to avoid narrowing spreads too far.
Under MiFID II, all orders HFT orders generated by an algorithm will have to be flagged. This will allow competent authorities, such as the FCA, to identify and distinguish orders originating from different algorithms and to further understand the strategies that HFT traders employ.
In a further measure to dissuade some forms of HFT strategies, trading venues will be allowed to adjust their fees for cancelled orders according to the length of time for which the order was maintained and to calibrate those fees to specific financial instruments.
The future for HFT
The electronic trading sector has been inundated with regulation since technological advancements were first applied in this area. These advancements have helped the sector achieve exponential growth and regulators have now been tasked with the difficult task of protecting the integrity of the market while not stifling innovation.
Research, such as that by Dobrev and Schaumburg, highlights the fact that the effect of HFT on markets is not yet fully appreciated by market participants or regulators. As a result of this regulation in this area is still developing. MiFID II will bring significant changes in the area and it is not yet clear as to how HFT firms will adapt. Following its own research on HFT, ESMA concluded that further research is needed to assess the actual contribution of HFT to liquidity and analyse potential risks and benefits linked to HFT activity.
Legislation in respect of HFT in this absence of clear evidence and understanding of the subject matter brings an increased risk of unforeseen and unintended consequences. What is clear, however, is the need for all market participants to remain up to date with technological change.
To discuss any of the matters raised above please contact the Financial Regulatory team at Kemp Little.
 ESMA Economic Report on High-frequency trading activity in EU equity markets Number 1, 2014.