High%Frequency%Trading%Literature%Review% October%2011!

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1 High%Frequency%Trading%Literature%Review% October%2011 This brief literature review presents a summary of recent empirical studies related to automatedor highfrequencytrading (HFT)anditsimpactonvariousmarkets.Eachstudy takes a unique approach, yet all paint a consistent picture of markets being improved by competitionandautomation. % Author(s)%/%Title% % % Dataset% Findings% Angel,Harris,Spatt "Equitytradinginthe21st century",february2010 RGMAdvisors MarketEfficiencyand MicrostructureEvolutioninUS EquityMarkets:AHigh FrequencyPerspective, October2010 CreditSuisse SizingUpUSEquity Microstructure,April2010 U.S.equities, U.S.equities,2006M2010 U.S.equities,2003M2010 Tradingcostshavedeclined, bidmaskspreadshavenarrowed andavailableliquidityhas increased BidMaskspreadshave narrowed,availableliquidity hasincreasedandprice efficiencyhasimproved BidMaskspreadshave narrowed,availableliquidity hasincreasedandshortmterm volatility(normalizedbylonger termvolatility)hasdeclined Hasbrouck,Saar "LowMLatencyTrading",May 2011 U.S.equities,fullNASDAQorder book June2007andOctober2008 Lowlatencyautomatedtrading wasassociatedwithlower quotedandeffectivespreads, lowervolatilityandgreater liquidity Hendershott,Riordan AlgorithmicTradingand Information,August2009 Chaboud,Hjalmarsson,Vega andchiquoine RiseoftheMachines: AlgorithmicTradinginthe ForeignExchangeMarket, October2009 Automatedvs.othertrades. DeutscheBörseequities, January2008 Automatedvs.othertrades. EBSforexmarket,2006M2007 Automatedtradesmadeprices moreefficientanddidnot contributetohighervolatility Automatedtradesincreased liquidityandmayhavelowered volatility 1

2 2 % Author(s)%/%Title% % % Dataset% Findings% MarketsCommittee,Bankfor InternationalSettlements(BIS) HighMfrequencytradinginthe foreignexchangemarket, September2011 VariousFXvenues,notably ReutersandEBS,andvarious dates,notablymay6,2010and March17,2011 HFTisfoundtobebeneficial duringnormalmarketperiods, withsimilarbehaviorto traditionalmarketparticipants duringhighvolatilityperiods Brogaard "Highfrequencytradingandits impactonmarketquality", August2010 HFTvs.othertrades.U.S. equitiesonnasdaq,various periodsin HFThelpedtonarrowbidMask spreads,improvedprice discoveryandmayhave reducedvolatility Brogaard HighFrequencyTradingand Volatility,October2011 HFTvs.othertrades.U.S. equitiesonnasdaq,various periodsin HFTactivitytendstodecrease idiosyncraticandintraday volatility. Hendershott,Riordan HighFrequencyTradingand PriceDiscovery (working paper) HFTvs.othertrades.U.S. equitiesonnasdaq,various periodsin HFTtradeswerepositively correlatedwithpermanent pricechangesandnegatively correlatedwithtransitoryprice changes,suggestingthathft improvespricediscovery Jarnecic,Snape "Ananalysisoftradesbyhigh frequencyparticipantsonthe LondonStockExchange",June 2010 HFTvs.othertrades. LSEequities,April June,2009 HFTimprovedliquidityand wasunlikelytohaveincreased volatility CMEGroup "Algorithmictradingand marketdynamics",july2010 Automatedvs.othertrades. CMEfutures,May2008 May 2010 Automatedtradingwas associatedwithimproved liquidityandreducedvolatility Menkveld HighFrequencyTradingand thenewmmarketmakers,april 2011 DutchequitiestradedonChiMX andeuronext,2007 Asinglehighfrequencytrader playedanimportantroleinthe developmentofacompetitive marketcenter,resultingin betterliquidityandlower tradingcosts Lepone TheImpactofHighFrequency Trading(HFT):International Evidence,September2011 HFTvs.othertrades.Singapore Exchange(SGX),Australia SecuritiesExchange(ASX), NASDAQandLondonStock Exchange HFThasbecomeamajor providerofliquidity, particularlyduringperiodsof marketuncertainty

3 % Author(s)%/%Title% % % Dataset% Findings% Hendershott,Jones,Menkveld DoesAlgorithmicTrading ImproveLiquidity?,February 2011 Riordan,Storkenmairm Latency,LiquidityandPrice Discovery,2009 Automatedquotingfacility, NYSEequities,2003 XetrahighMspeedtrading system,deutschebörse,2007 Automatedtradingnarrowed bidmaskspreads,lowered tradingcosts,andimproved priceefficiency Highersystemspeedsledto increasedliquidityand improvedpricediscovery Hendershott,Moulton Automation,SpeedandStock MarketQuality:TheNYSE s Hybrid,February2010 NYSETAQdatabaseplusothers, June1,2006MMay31,2007 Introductionofautomationvia thenysehybridsystem improvedpricediscoveryand madepricesmoreefficient Gomber,Arndt,Lutat,Uhle HighMFrequencyTrading, March2011 Various Surveypaperthathighlights beneficialaspectsofhft,while notingthatperceivedproblems arelargelyaresultofu.s. marketstructure % This%following%studies%measured%improvements%in%overall%market%quality:% Angel,%Harris%and%Spatt%(February%2010)examinedmanymeasuresofmarketqualityand howtheyhavechangedovertimeandinresponsetoregulatoryandstructuralchangesinthe U.S.equitymarkets. 1 Drawingfromadiversesetofdatasources,theyshowthattherehas beensignificantimprovementinvirtuallyallaspectsofmarketquality.theystate"execution speedshavefallen,whichgreatlyfacilitatesmonitoringexecutionqualitybyretailinvestors. Retailcommissionshavefallensubstantiallyandcontinuetofall.BidMaskspreadshavefallen substantially and remain low, although they spiked upward during the financial crisis as volatility increased. Market depth has marched steadily upward. Studies of institutional transactionscostscontinuetofindu.s.costsamongthelowestintheworld." RGM%Advisors,%LLC%(October%2010)studiedrecentdatafromtheU.S.equitymarkets. 2 The authors examined trends in a number of U.S. equity market quality metrics over the period from January 2006 through June 2010 and how these metrics differed by market capitalizationandbylistingvenue.theypresenteddatathatconfirmedthatoverthisperiod quotedbidmaskspreadsdeclined,quotedmarketdepthincreasedandshortmtermmeasuresof marketefficiencysignificantlyimproved. 1 Angel, J., Harris, L. and Spatt, C., "Equity trading in the 21st century", 2Castura,J.,Litzenberger,R.,Gorelick,R.,andDwivedi,Y.,2010: MarketEfficiencyandMicrostructure Evolution in US Equity Markets: A High Frequency Perspective, 3

4 Credit% Suisse% (April% 2010)releasedareportonrelatedtopicsandshowedthatinrecent years, bidmaskspreadsdeclined,depthattheinsidequoteincreasedandintramday volatility normalizedbylongermtermvolatilitydeclinedsubstantially. 3 Theauthorsconcludedonthis last point that [t]his seems to be confirmation that the new market participants are successfully finding and removing mispricings, as well as dampening volatility that might otherwisebecreatedbylargeinstitutionalordersfilledduringtheday. Hasbrouck% and% Saar% (October% 2010) explored the nature and impact of lowmlatency (algorithmic)tradingonthenasdaqexchangeduringjune2007,a'nominal'marketperiod, and October 2008, a volatile, uncertain period. 4 They identified periods of high market activity due to algorithms and relate these to longermterm market quality metrics such as spread,effectivespreadanddepthofliquidity.theyobserveinbothperiods thathigherlowm latency activity implies lower posted and effective spreads, greater depth, and lower shortm termvolatility. The%following%studies%examined%market%data%sets%that%distinguished%between%automated% trades%and%other%trades:% Hendershott%and%Riordan%(August%2009)reportedontheimpactofautomatedtradingon thedeutschebörse sxetramarket,anequitymarketwhereautomatedtradingactivitycould bedistinguished. 5 Thepaperfoundthatautomatedtradingaccountedforabouthalfofthe total volume in the top 30 volume stocks, and that automated trading was better than nonm automated trading at driving prices toward efficiency. The authors also showed that automated trading "contributes more to the discovery of the efficient price than human trading." Furthermore, they find there is"no evidence of[automated trading] behavior that wouldcontributetovolatilitybeyondmakingpricesmoreefficient." Similarly, in the foreign exchange market, Chaboud,% Hjalmarsson,% Vega% and% Chiquoine% (October% 2009) used a dataset that separately identified computer generated trades from humangeneratedtradesandshowedthatanincreaseinautomatedtradingmaybeassociated with less market volatility, and that automated traders tend to increase liquidity provision afterexogenousmarketeventssuchasmacroeconomicdataannouncements. 6 The%Bank%for%International%Settlements%(September%2011)releasedarelatedstudyonthe impactthatgrowinghftparticipationhashadontheforeignexchangemarket. 7 Theauthors based their findings on observations made from several banks and other foreign exchange 3 Credit Suisse, 2010: Sizing Up US Equity Microstructure, 4 Hasbrouck, J. and Saar, G, LowMLatency Trading, 5 Hendershott, T. and Riordan, R., 2009: Algorithmic Trading and Information, HendershottandRiordan(2009) ) 6Chaboud,Alain,Hjalmarsson,Erik,Vega,ClaraandChiquoine,Ben, RiseoftheMachines:Algorithmic Trading in the Foreign Exchange Market (October 2009). Federal Reserve Board International Finance Discussion Paper No. 980, ( Chaboud, Hjalmarsson, Vega and Chiquoine (2009) ) 7 Bank for InternationalSettlements, HighMfrequency trading in the foreign exchange market (September,2011), 4

5 markets, in addition to using historical data from Reuters and EBS, two of the largest FX trading platforms. They cited a general consensus that HFT benefits the markets under normal conditions, and therefore focused on two significant FX shocks: May 6, 2010 and March17,2011.Inbothcases, theyfoundevidencesuggestingthathftdidnotwithdraw from trading during the shocks, and that they may have been quicker to resume normal tradingastheshocksstabilizedthantraditionalmarketparticipants. Brogaard%(August%2010)investigatedtheimpactof highfrequencytrading or HFT onus equity trading on the NASDAQ exchange. 8 Usingadatasetprovidedbytheexchangethat labeled all activity as either 'HFT' or 'everything else', Brogaard examined the exact impact that HFT participants have on the market. His analysis used a wellmknown regression framework to isolate various factors in the market and how HFT impacts each of these. In particular,heshowsthathftactivitycontributesmoretopricediscoverythanotheractivity, thathftquotesareatthebestbidorbestaskpriceabout50%ofthetime,thathftreduces priceimpact(animportantcomponentoftradingcosts)forotherparticipants,andthathft activityreducesvolatility. Brogaard% (October% 2011) used the same data set to investigate the impact of HFT on volatility. 9 He performed a series of measurements in an attempt to determine the causal nature of the relationship between HFT activityand volatility. He found evidence that HFT liquidity provision increases during times of shortmterm volatility, but decreases during periods of longmterm volatility. Using the 2008 shortmsale ban as an exogenous control variable of HFT activity levels, Brogaard found that restrictions that reduced HFT participationleadtohighervolatility. Hendershott% and% Riordan% (2011) examined the impact of HFT on the price discovery processusingthesamedatasetusedinbrogaard(2010). 10 OveralltheyfoundthatHFTtrades are positively correlated with permanent price changes, thereby aiding price discovery, and are negatively correlated with temporary pricing errors, thereby improving the price discovery process. By distinguishingtradesinitiatedbyanhft, theauthorsfoundthat marketablehighfrequencytradesactivelydrivepricestowardsfairvalue. AsimilarstudydonebyJarnecic%and%Snape%(June%2010)useddataprovidedbytheLondon StockExchange(LSE). 11 LiketheNASDAQdataset,thissetlabeledallactivitybyparticipant type;hft,investmentbank,retail,etc.,providingafinergranularityofparticipationratesand behaviors.theauthorsusedasimilarregressionframeworkasbrogaardinordertoisolate the impact of HFT on various market metrics. They found that HFT participants tend to provide liquidity when spreads are wide, demand liquidity when spreads are narrow, that theyaremorelikelyto"smoothoutliquidityovertimeandareunlikelytoexacerbatestock pricevolatility". 8 Brogaard, J., "High frequency trading and its impact on market quality", 9 Brogaard, J., "High frequency trading and volatility", 10Hendershott,T.andRiordan,R.,2011: HighFrequencyTradingandPriceDiscovery,workingpaper 11 Jarnecic,E.andSnape,M.,"AnanalysisoftradesbyhighfrequencyparticipantsontheLondonStock Exchange", 5

6 The% CME% Group% (July% 2010) released a report on automated trading activity on the CME futuresexchange. 12 Theylabeledallparticipantsaseither ATS (automatedtradingsystem) or nonmats. Theycomparedtradevolumeandmessagingratesforeachparticipantagainst marketmeasuressuchasliquidityandvolatility.ats'simpactonthesemeasuresvariesby futurescontract,butasawhole,theyconcludedthatatsmbased"volumeandmessagetraffic tendtobeassociatedwithenhancedliquidityandreducedvolatility". Menkveld%(April%2011)studiedthedevelopmentoftheChiMXEuropeanstockMTFin2007 andthesimultaneousentryofalargehighfrequencytradingparticipantonchimx. 13 Hefound thatthisnewparticipantwaslargelyresponsiblefortheincreaseinmarketshareofchimxand ultimatelyledtoreducedspreadsforthestocksthatittraded. Lepone%(2011) summarized the results of a series of research conducted by the Australian organization Capital Markets Cooperative Research Centre (CMCRC). 14 Thesepapers examined the impact of HFT on market quality for exchanges based in Singapore, Australia, the U.S., andthe United Kingdom. Their data allowed them to identify trading participants and classify them into HFT and nonmhft groups. Following a methodology similar to Brogaard(2010),eachofthesepapersmeasuredtheimpactofHFTonmarketqualitymetrics. Thefindingsshowedaconsistentpatternofimprovedmarketqualitycoincidingwithgrowing HFTparticipation.TheyalsodemonstratedthatHFTisactiveduringallvolatilityconditions and becometheprimaryprovidersofliquidity inperiodsofhighuncertainty. These%event%studies%investigated%the%impact%of%improvements%to%a%market%center s%trading% technology:% Hendershott,%Jones%and%Menkveld%(2007)examinedtheimpactontheNYSEoftheirautoM quotingfacilityintroducedin Thisstudyshowedthatforallstocks,andparticularly largemcap stocks, automated trading increased liquidity. It also demonstrated that the increaseinautomatedtradingcausedareductionineffectivespreads,therebyreducingcosts toinvestors. Similarly,%Riordan% and% Storkenmairm% (2009)reportedonhowa 2007 upgrade to the DeutscheBörse sxetratradingsystemfocusedsolelyonlatencyreduction,positivelyaffected market quality. 16 After latency reductions in the exchange s trading systems, liquidity increasedacrossmarketcapitalizationandtradesizes,andadverseselectionandpermanent priceimpactweredramaticallyreduced. 12 The CME Group, "Algorithmic trading and market dynamics", 13 Menkveld, A., 2011: High Frequency Trading and the NewMMarket Makers, available from 14 Lepone,A.,2011: TheImpactofHighFrequencyTrading(HFT):InternationalEvidence,available fromthecmcrc: 15 Hendershott,T.,Jones,C.M.andMenkveld, A.J.,: DoesAlgorithmicTradingImproveLiquidity?, JournalofFinance,VolumeLXVI,No.1,February Riordan, R. and Storkenmairm, A., 2009: Latency, Liquidity and Price Discovery, 6

7 Hendershott% and% Moulton% (February% 2010)studiedtheintroductionoftheNYSEhybrid systemin2006,whichmovedthenysetoafasterandmoreautomatedmatchingsystem. 17 Theyfoundthatpricesbecamemoreefficientduetofasterpricediscoveryandreducednoise inprices. This% paper% provides% an% overview% of% high% frequency% trading % and% related% market% structure%issues:% Gomber% et% al% (March% 2011) presented background information on HFT. Their paper analyzed HFT and certain proposed regulatory measures. 18 They claimed that HFT is a technology rather than a strategy, and is a natural evolution in the market place. They highlighted the beneficial aspects that HFT can provide, and noted that perceived problems withhftarelargelyaresultofu.s. marketstructure rather than anything inherent in HFT itself. They provided several recommendations for policy makers that would maintain the beneficialaspectsofhftwhileprovidingmarketswithadditionalsafety. 17Hendershott,T.andMoulton,P.,February2010: Automation,Speed,andStockMarketQuality:The NYSE's Hybrid, papers/documents/automationspeedhybrid_accepted.pdf 18 Gomber, P., Arndt, B., Lutat, M., and Uhle, T., March 2011: HighMFrequency Trading, 7