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The Impact of Message Traffic Regulatory Restrictions on Market Quality: Evidence from Chi-X Canada

The Impact of Message Traffic Regulatory Restrictions on Market Quality: Evidence from Chi-X Canada

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The contemporary growth in Algorithmic Trading (AT) has occurred in a dynamic financial market, realized through the active relation between regulatory development, firm and market competition, as well as significant technological changes. Despite recent empirical research suggesting
a positive relation between AT and improvements to market quality, several market participants still question the tangible benefits of AT. Recently several market regulatory bodies have proposed or implemented cost recovery and fee models that charge brokers for market participation on a pro rata basis with respect to message traffic and trading activity. Findings suggest that high order-to-trade ratio trading strategies, often characterized as HFT, are linked to improvements in spread and depth measures of liquidity on Chi-X Canada. Furthermore, the implementation of IIROC’s Integrated Fee Model on April 1, 2012 has coincided with a decline in quote submission, trades, volume, and deterioration of liquidity. The relation between order-to-trade measures, that proxy for AT, and liquidity measures deteriorates following the implementation of the IIROC 2012 Integrated Fee Model.
The contemporary growth in Algorithmic Trading (AT) has occurred in a dynamic financial market, realized through the active relation between regulatory development, firm and market competition, as well as significant technological changes. Despite recent empirical research suggesting
a positive relation between AT and improvements to market quality, several market participants still question the tangible benefits of AT. Recently several market regulatory bodies have proposed or implemented cost recovery and fee models that charge brokers for market participation on a pro rata basis with respect to message traffic and trading activity. Findings suggest that high order-to-trade ratio trading strategies, often characterized as HFT, are linked to improvements in spread and depth measures of liquidity on Chi-X Canada. Furthermore, the implementation of IIROC’s Integrated Fee Model on April 1, 2012 has coincided with a decline in quote submission, trades, volume, and deterioration of liquidity. The relation between order-to-trade measures, that proxy for AT, and liquidity measures deteriorates following the implementation of the IIROC 2012 Integrated Fee Model.

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Published by: tabbforum on Mar 26, 2013
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07/10/2013

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The Impact of Message Traffic Regulatory Restrictions on Market Quality: Evidence from Chi-X Canada
Andrew Lepone
a
, Alexander Sacco
aa
Discipline of Finance, University of Sydney, N.S.W., 2006 Australia
 
Abstract
The contemporary growth in Algorithmic Trading (AT) has occurred in a dynamic financial market, realized through the active relation betweenregulatory development, firm and market competition, as well as significant technological changes. Despite recent empirical research suggestinga positive relation between AT and improvements to market quality, several market participants still question the tangible benefits of AT.Recently several market regulatory bodies have proposed or implemented cost recovery and fee models that charge brokers for market participation on a pro rata basis with respect to message traffic and trading activity. Findings suggest that high order-to-trade ratio tradingstrategies, often characterized as HFT, are linked to improvements in spread and depth measures of liquidity on Chi-X Canada. Furthermore, theimplementation of IIROC’s Integrated Fee Model on April 1, 2012 has coincided with a decline in quote submission, trades, volume, anddeterioration of liquidity. The relation between order-to-trade measures, that proxy for AT, and liquidity measures deteriorates following theimplementation of the IIROC 2012 Integrated Fee Model.
 Keywords
:
Algorithmic Trading; High Frequency Trading; Liquidity; Market Microstructure
 JEL Classification
: G10
 
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INTRODUCTION
Recent research generally suggests a relation between high quote message traffic and trading activity, and improving market quality; increasingliquidity, price discovery, and reduced volatility (Hendershott, Jones, and Menkveld, 2011; Hasbrouck and Saar, 2010; Brogaard, 2012).Academic studies, including Hendershott, Jones, and Menkveld (2011), and a range of market participants attribute this high quote messagetraffic and trading activity to the recent increased incidence of Algorithmic Trading (AT) and High Frequency Trading (HFT). Some market participants, nonetheless, remain skeptical of the advantages of trading in a market that has prevalent AT and HFT, for fear of their perceivedspeed and informational advantage, and propensity to exasperate volatility (CESR 2010a, 2010b; Easley, Lopez de Prado, and O’Hara 2011;European Parliament, 2010).This paper examines the association between high order-to-trade (OTT) ratio trading strategies; commonly used as a proxy for AT, and broader liquidity based market quality metrics for the ATS Chi-X Canada. Using the implementation of Investment Industry RegulatoryOrganization of Canada’s (IIROC) Integrated Fee Model on the 1 April 2012, this study is able to examine the impact of regulators’ fee modelsthat are allocated pro rata with respect to participants’ quote message traffic and trading strategies, on quote message traffic, trading strategies,and market quality. To establish causality this study incorporates this important exogenous event that is expected to decrease the amount of message traffic and trading activities in stocks on Chi-X Canada.
 
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IIROC implemented the Integrated Fee Model on April 1, 2012, which involved a fee model that allocates IIROC’s annual operating costto two pools comprising of unique costs for each of Dealer and Market regulation. Of particular interest to this study is the Market RegulationFee Model; IIROC is one of the first financial regulators globally, along with ASIC (Australia), to propose and implement a fee structure torecover market regulatory costs based on participants’ message traffic and trading activity. IIROC estimates that approximately 85% of firmswill see a decrease based on the new market regulation model, while 15% of firms will experience a fee increase (IIROC, 2012). The 15% thatare expected to experience a fee increase are firms that contribute a greater number of message traffic and trading activity, that is, HFT firms.This study is motivated to examine the impact of pro rata message traffic and trading activity cost recovery measures of trading activity andmarket quality.HFT is a subset of AT; which is commonly defined as the use of computer algorithms to automatically make certain trading decisions,submit orders, and manage those orders after submission (Hendershott, Jones, and Menkveld 2011). High Frequency Traders (HFTrs) arecharacterized by IIROC (2012) as having an order submission-to-trade ratio of greater than 3, with more than 1000 daily trades. Whilst HFT is asubset of AT, not all forms of AT can be attributed to HFTrs. For instance, the SEC (2010) characterizes proprietary firms engaged in HFT as:“(1) the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders; (2) use of co-location services and individual data feeds offered by exchanges and others to minimize network and other types of latencies; (3) very shorttime-frames for establishing and liquidating positions; (4) the submission of numerous orders that are cancelled shortly after submission; and (5)ending the trading day in as close to a flat position as possible”.

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