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Chicago FED on HFT

Chicago FED on HFT

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Chicago FED on HFT
Chicago FED on HFT

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Published by: zerohedge on May 21, 2013
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Recommendations for EquitableAllocation of Trades in High Frequency  Trading Environments
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 John McPartland
Executive Summary 
Most industry observers and much of the academic research in this area haveconcluded that High Frequency Trading (HFT) is generally beneficial. Many institutional investors, however, believe that HFT places them at a competitivedisadvantage. Digital computers will always have some structural (speed)advantages over human traders. This is inevitable. This paper (1) acknowledges and summarizes much of the relevant publishedresearch
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(2) discusses some of the HFT strategies that likely run counter togood public policy and (3) makes six recommendations that, if implemented,would not preclude any current HFT strategies, but would likely restore somecompetitive advantage to market participants that would be willing to exposetheir resting orders to market risk for more than fleeting milliseconds.Readers should avoid the tendency to review the Working Paper only within theframework of their own nationality and market domain. The paper is meant tobe global in scope. Some HFT practices that may be inappropriate (or banned)in some markets in some countries are alive and well in other markets in othercountries.
1
 
TheauthorwishestoacknowledgetheverysignificantcontributionsthatDavidMarshallandRajeevRanjanmadetothispaper.Healsowishestothankthemanyindustryprofessionalswhohelpedreviewthemanyversionsofthedocumentanditsrecommendationspriortopublication.Anyopinionsexpressedinthispaperarethoseoftheauthor,andthoseopinionsdonotnecessarilyreflecttheopinionsoftheFederalReserveBankofChicagoortheopinionsoftheBoardofGovernorsoftheFederalReserveSystem.
2
See,forexample,AntonGolub,2011,
“Overviewof
highfrequencytrading,
”Manchester
BusinessSchool,April15,andInvestmentIndustryRegulatoryOrganizationofCanada,2012,
“TheHOTStudy:PhasesIandIIofIIROC’ss
tudyofhighfrequencytradingactivityonCanadianequitymarketplaces,
”
report,Toronto,December12.
 
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An exceptionally abbreviated summary of the six recommendations follows.1.
 
Where appropriate, utilize a new trade allocation formula that isintermediate between the Pro Rata trade allocation formula and thePrice/Time or FIFO trade allocation formula.2.
 
Create a new, optional, term limit order type that, as part of the tradeallocation process, would reward traders for the time that their ordersare committed to be resting in the Order Book.3.
 
Completely dark orders or the hidden portion of resting orders that arenot fully displayed (lit) in the Order Book should go to the very end of thequeue (within limit price) with respect to trade allocation.4.
 
Prior to trade allocation, multiple small orders from the same legal entity entered contemporaneously for the sole purpose of exploiting therounding conventions of a trading venue should firstly be aggregated as asingle order and should carry the lowest allocation priority time stamp of all of the orders so aggregated.5.
 
Rather than running a continuous trade match, trading venues shoulddivide their trading sessions into periods of one half second. At acompletely random time within each half second period, the trade matchand trade allocation algorithms should be run once.6.
 
Visibility into the Order Book should be no more granular than aggregatesize at a limit price. Market participants should neither be able to viewthe size of individual orders nor any other identifiers of any orders of others. This more granular information is not information that any market participant needs to make a fully informed economic decision asto the instantaneous value of the instrument being traded.
Background 
Most industry observers seem to believe that HFT offers many benefits toorganized financial markets and to society, including improved liquidity,tightened bid/offer spreads and a decrease in intraday price volatility. ThisWorking Paper describes some of the HFT techniques that have developed inelectronic markets around the world.
 
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Different financial centers have different rules and regulations regarding theappropriateness of some HFT techniques. This Working Paper is intended to beglobal in its scope and in its recommendations. All of its six recommendationsmight not be appropriate for every electronic exchange in every financial center. Throughout the Working Paper, when discussing different trade allocation
methodologies, we refer to “shares”
,
“futures” or “lots”; these terms are
completely interchangeable.
Review of the Academic Literature 
 
Brogaard, Hendershott and Riordan (2012) analyzed NASDAQ and NYSE highfrequency trading data
4
that show high frequency traders increase priceefficiency by trading in the same direction of permanent price changes andtrading in the opposite direction of transitory pricing errors on normal tradingdays and on days with the highest price volatility. In contrast, HFT liquidity-supplying non-marketable orders are adversely selected in terms of thepermanent and transitory components as these trades are in the directionopposite to permanent price changes and in the same direction as transitory pricing errors. HFT predicts price changes in the overall market over shorthorizons measured in seconds. HFT is correlated with public information,such as macro news announcements, market-wide price movements, and limitorder book imbalances.
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  Jones (2013) notes that the volume of HFT has increased sharply over the pastseveral years, has reduced trading costs and has steadily improved liquidity. The main positive is that HFT can intermediate trades at lower cost. However,HFT speed could disadvantage other investors, and the resulting adverseselection could reduce market quality. Ideally research in this area shouldattempt to determine the incremental effect of HFT beyond other structural andtechnological changes in equity markets. The best papers for this purposeattempt to isolate market structure changes that facilitate HFT. Virtually every time a market structure change results in more HFT, liquidity and marketquality have improved because liquidity suppliers are better able to adjust their
3
 
SeeInvestmentIndustryRegulatoryOrganizationofCanada(2012,appendixA,pp.51
 – 
56).
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TheHFTdatarepresentasampleof120randomlyselectedstockslistedonNASDAQandNYSEforallof2008and2009.Tradesaretime-stampedtothemillisecondandidentifytheliquiditydemanderandsupplierasahighfrequencytraderornon-highfrequencytrader.
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JonathanBrogaard,TerrenceHendershottandRyanRiordan,2013,
“High
frequencytradingandpricediscovery,
UniversityofWashington,UniversityofCalifornia,BerkeleyandUniversityofOntarioInstituteofTechnology,workingpaper,April22.

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