Jonathan Seddon, Audencia Business School
For centuries, there have been two participants in financial markets, one is a broker or a low-frequency trader (LFT) working on an exchange, and the other is an investor. In 1964, an IBM computer introduced algorithmic trading on the New York Stock Exchange. This is to change the way the market will operate in the future.
Financial markets have always periodically shifted from prosperity to depression, bringing about changes in the way business operates. Perhaps the most significant change took place after the 2008 financial crisis. Before that, the United States had spent two years introducing the Reg. In Europe, the Mifid has been enacted. Its purpose is to make the market transparent by providing a structure for market decentralization and to ensure that investors regard the market as fair and efficient. However, the legislation opens the door to third-party high-frequency traders (HFT). Markets at that time were not inherently efficient, and these financial institutions could benefit from price differentials because they provided liquidity to find fair prices. Today, high-frequency trading provides most of the liquidity, operates with greater spreads and reduces the profits of other suppliers.
High-frequency trading is a subset of algorithmic trading. The new legislation opens the door for high-frequency trading, making high-frequency trading dominate some areas of the market, especially stocks and foreign exchange. Now, in competition with other trading places, traditional exchanges are looking for ways to attract liquidity. Although LFT initially provided this, it was no longer valid as a return for not charging transaction fees, the actual location of privileges in the trading hall, and limiting the number of LFTs per share. Instead, exchanges now offer fees to those who can provide (mostly) liquidity to earn fees without any contractual obligations. Special types of orders have been developed and their existence or use is not disclosed (Direct Edge was fined $14 million in 2015). Decentralized market structure means that companies that can get different prices for the same securities can make profits through arbitrage. Since 2007, HFT has been engaged in technical warfare to reduce delays, such as plans to build 300-metre-high microwave towers, in an attempt to reduce the time between London and Frankfurt by milliseconds. Exchanges have also seen opportunities to sell joint positioning to their matching engines and to provide data sources to companies wishing to get information as soon as possible.
High-frequency trading represents a paradigm shift in the way our market operates. Unlike other investors, high-frequency trading does not care about the profit opportunities of holding company shares, but promotes its strategic turnover. With small orders, they buy and sell batches of shares between 100 and 200 at a fraction of the price.
Liquidity is a by-product of these strategies, which, according to the law of large numbers, allow them to make profits all day. With robots, they have removed any emotion from their strategy, and they will trade as soon as possible, instead of waiting to see if they can earn more. Statistical controls are used to help manage purchased goods so that they can be closed at the end of each day without holding any stock risk. Using artificial intelligence and advanced system development, the mathematical model is transformed into code. Economic trends are not the driving force behind decision-making, but rather the analysis of a large number of data sets and historical patterns to help predict future events. This code is not static, but will be updated with changes in market conditions and loss of opportunities.
Traditional activities that fund managers seek to trade at intervals are used by HFT for pattern recognition. HFT scans billions of records, searches for patterns or footprints, and provides statistical opportunities, which some call front-end operations. These comments are based on the fact that high-frequency trading provides liquidity and is not interested in holding any stocks, so their activities must be suspicious. These reviews are driven by fear of robotic behavior and have nothing to do with how the market works today. How can you execute a large order in advance when the batch is hundreds and the order details are hidden (Mifid encourages the use of iceberg order types)? How can you buy all the other stocks (get liquidity and pay for them) and then top the list of orders on the other hand, ahead of all the other companies that compete with you? This is a more important cooperation. It takes less time than a broker is convicted of such acts.
Financial markets are now imposing record fines for bad behaviour. In January, the Financial Conduct Authority (FCA) imposed a 163 million pound fine on Deutsche Bank for money laundering. In January 2016, the Securities and Exchange Commission (SEC) and the New York Attorney General's Office (NYAG) collectively fined Barclays Capital Inc. and Credit Suisse Securities (USA) LLC over $150 million for black pool violations. It is clear that there are abuses and fraudulent practices in the market, such as Navender Sarao's recent admission of using computers to send false orders to the Chicago Mercantile Exchange (which contributed to the 2010 flash crash).
When Mifid II comes into effect in January 2018, our need for transparency and accountability will improve as more transactions take place in a structured and orderly market. However, record fines only weaken investors'confidence that the market is the best place for them to invest. This lack or weakening of confidence, coupled with the story of how the market was manipulated, is no longer fair to ordinary investors. Since registration, questions about HFT activities have been raised. NMS and Miid have been enacted. Are investors suffering from the illusion of liquidity? How does regulation control a robotic system? The efficient market hypothesis is obviously inconsistent with the ability of high-frequency trading to move in a known direction.
It is difficult to study high-frequency trading because their operations are highly confidential, because they differ from the inefficient micro-price of other high-frequency trading markets. They are proprietary and do not need to attract outside investors (as investment companies show their portfolios). There is a clear conflict between the business models used by HFT and LFT. Since liquidity is no longer available to all markets at decimal prices, LFT's profits are squeezed as spreads tighten. Because of the use of high frequency strategy, the overhead structure of high frequency transformer is different from that of low frequency transformer, so it can be profitable. Some people think that high-frequency trading is parasitic, because their behavior does not add new information. Instead, they only make profits through unnecessary trading. Others think that the reduction of price spreads means that long-term investors have better trading when they buy and sell. Since there is no formal contract to provide liquidity, some comment that high-frequency trading only takes place when it is profitable and stops trading when it sends informed transactions. Others say that in the past, when the market turned around, brokers chose to take long breaks rather than pick up the phone. Other studies have shown that high-frequency trading has high activity when volatility rises.
How to ensure market fairness and transparency? All regulation should promote price discovery. Long-term investors must be able to execute in highly liquid and efficient markets. For those who argue for tighter spreads, lower volatility and higher efficiency, there are others who can point out contradictory studies. People cite shadow liquidity, the stock you can get when you try to trade and then disappear, as clear evidence that high-frequency trading is gambling in the market. However, another study 1 also observed the cancellation of the S& P 500 index, arguing that the most common event after the cancellation was another offer to replace it. At present, there is no clear evidence of how the market works. If we can come up with any conclusive arguments, more detailed research is needed. Clearly, the market consists of three players: investors, LFT and HFT. This conflict occurs between LFT and HFT, both of which want to profit from their trading activities, which are solely aimed at creating liquidity for long-term investors. High-speed trading is not without problems. However, because some companies are unfair to go too fast, slowing down the market is a setback. The speed at which investors identify stocks, trade and settle accounts reflects the improvement of market efficiency. Those illegal activities need to be punished. These market-strengthening activities need to be monitored, but encouraged. If HFT is a problem for LFT because it cannot compete, the question is whether LFT is now redundant.