Economics & Finance
• 5 minute read
Can Competition Between High-Frequency Traders Actually Reduce Market Volatility?
Contrary to concerns over correlated HFT activity, research suggests competition, especially between HFT market makers, may lower market fragility
By Jaymee Ng, Principal Writer, China Business Knowledge @ CUHK
High-frequency trading, also known as HFT or algorithmic trading, uses computer algorithms to transact a large amount of orders within a blink of an eye. According to Nasdaq, it is estimated that 50 percent of the stock trading volume in the U.S. is driven by HFT. This trading method has attracted much attention, having been widely attributed to contributing to the “flash crash” on May 2010, when the Dow Jones index lost near 1,000 points in a matter of minutes.
Prof. Dan Li, Associate Professor in the School of Management and Economics at The Chinese University of Hong Kong Shenzhen, who specialises in market microstructure and empirical corporate finance with a focus on HFT, capital market, liquidity, and entrepreneurship, recently published a research paper examining HFT patterns.
“The HFT industry is shrouded in secrecy. Most HFT firms are private and hence reveal no financial or operating information; detailed information about proprietary trading desks of larger, publicly listed firms are seldom disclosed to the public. In general, HFT firms do not reveal information about the objectives of their algorithms beyond speaking generally about concepts such as ‘liquidity provision’ and ‘arbitrage’,” Prof. Li comments.
Entitled “The Competitive Landscape of High-Frequency Trading Firms”, the study was conducted by Prof. Li in collaboration with researchers from Singapore Management University and Cornell University. It uses principal component analysis to detect the trading strategies of HFT firms and how competition in each strategy space affected the market environment. The research team gathered data from the Investment Industry Regulatory Organization of Canada, the national self-regulatory organization that oversees all equity trading venues in Canada. Their sample consists of S&P/TSX 60 Index stocks. They analysed activity from a picked selection of 30 days that included bullish, bearish, and neutral trading environments between June 2010 and March 2011.
“Our results suggest that competition between HFT intermediaries could lead to faster revelation of hard information signals, lowering adverse selection costs and hence reducing volatility induced by the permanent price impact of trades.” – Prof. Dan Li
Shrouded in Secrecy
“The strategies of these HFT firms are secretive insofar as we do not know their objectives, but we can measure their output: orders, cancellations, and trades. Each strategy creates a unique profile of orders, cancellations, and trades, but it is impossible to understand the nature behind any one strategy simply by observing millions of data points,” says Prof. Li.
The team found at least three distinct underlying common strategies followed by several HFT firms. They consisted of cross-venue arbitrage, market making and short-term directional speculation, respectively. In addition, the 14 HFT firms that do follow the common strategies account for 96.21% of the messages that HFT firms send to the market and 78.97% of the volume they trade. In other words, these competing HFT firms that follow the three common strategies generated most of the HFT activity in the Canadian equity market.
“While competition has desirable properties, if it means that HFT firms engage in strategies that are highly correlated across stocks, the central role these firms play in our markets could exacerbate return movements and increase short-horizon stock volatility,” Prof. Li says. However, the study uncovered the opposite, with competition between market making HFT firms leading to information being uncovered more quickly. This in turn leads to a more level playing between the buyer and the seller – or less “adverse selection” taking place, and lower volatility from permanent price changes.
“Our results suggest that competition between HFT intermediaries could lead to faster revelation of hard information signals, lowering adverse selection costs and hence reducing volatility induced by the permanent price impact of trades,” Prof. Li says.
“Competition in market making may also lower the compensation HFT market makers earn, which in turn explains the reduction in volatility that stems from the temporary price impact.” However, Prof. Li also notes that these conclusions may not hold in the event of a market breakdown such as the Flash Crash.
When examining how competition between HFT firms affect the market share of trading venues, Prof. Li and her collaborators discovered that similarity in HFT strategies benefits smaller and newly established trading venues that introduce competition into the market but detracts from the dominant position of the largest trading venue. This suggests that HFT competition enhances the viability of smaller trading venues by displaying better prices and smaller spreads, which then increases their market share.
Strategy Profitability
In terms of net trading revenues, the results show that firms that follow cross-venue arbitrage or short term speculative strategies have net trading revenues that are significantly higher than the net trading revenues of the firms that do not follow any of common strategies and higher than those that are market makers.
“In and of itself, our finding that there are at least three main product categories is important because it shows that thinking about HFT as a single entity in terms of its impact on the market may afford limited insights. We show that these three underlying common strategies differ from one another not just in terms of types of HFT activity, such as in cross-venue activity or passive liquidity provision, but also in terms of the market and limit-order book conditions associated with them,” Prof. Li explains. “These strategies serve different functions and should be regarded separately by both regulators and market participants.”
Commenting on the future research on this topic, Prof. Li admits that much work remains to be done.
“In particular, there is no evidence pertaining to the process of product development and testing in this industry, a process that has implications for both barriers to entry, or the amount of funding required to develop profitable algorithms, and the stability of the markets and the dangers of runaway algorithms that can wreak havoc and cause market disruptions. The importance of specific strategies for the well-functioning of our markets is also not completely understood,” says Prof. Li. “We view these as open questions and hope that future studies will be able to deepen our knowledge of this fascinating industry.”
