Future: how is the impact of computer-based trading on liquidity likely to evolve in the next ten years?

There is considerable uncertainty regarding the future role of HFT. TABB Group (2012) estimates that HFT accounted for 53% of trading in US markets in the first half of 2011, a decrease from the 61% share it held in 201054_{. However, the extreme market volatility in August 2011 saw HFT return}

with a vengeance. Wedbush, one of the largest providers of clearing services to high frequency firms, estimates that HFT made up 75% or more of US volume between 4 and 10 August 201155_{. Whether}

HFT will continue to be as active when volatility subsides to normal levels remains to be seen56_.

There are also indications that the profitability of HFT is reaching its limits and in the next ten years may come under further pressure. Such reductions may arise for a variety of reasons: the potential move to sub-penny pricing in the USA may reduce profitability from market making, new types of multi-venue limit orders may be permitted that will reduce the potential for stale prices across different trading venues, new entrants to the HFT industry will take profits from incumbents and regulation and taxation may make their business model unviable. Lowering costs of entry, which may arise from future technological improvements, can also improve competition. Limiting the value of small improvements in speed by, for example, reducing the value of time priority or requiring a minimum quote life, may also reduce HFT, because it will reduce the incentives for a winner-take-all speed race.

52 See http://www.sec.gov/divisions/marketreg/rule611faq.pdf for an explanation of the self help exception the NMS rules. Essentially, exchanges are allowed in exceptional circumstances (such as those occurring on May 6th, 2010) to not exchange messages with other exchanges, which would be their obligation under Regulation NMS. Accessed: 17 September 2012. 53 For a recent example, Thomas Cook (a FTSE 250 company at the time) closed on 21 November 2011 at 41.11 and closed

at 10.2 on 22 November 2011. The 75% loss of value was attributed to an announcement of bad results that took place before trading began. Most of the value loss was present at the opening of the market on the 22 November but the decline continued rapidly through the rest of the day (to the extent that it triggered a number of trading halts). There is some perception that this loss of value took place at a much faster pace than it would have done ten years ago.

54 TABB Group (2012). 55 Mehta (2011).

56 The increased activity of HFT during this volatile period seems at odds with some earlier arguments that their liquidity provision can reduce during times of market stress. Perhaps this illustrates the difference between regular volatility, which has both upside and downside price movements, and a market fall where only downside price changes occur.

Nonetheless, it seems inevitable that CBT will remain a dominant force in markets over the next ten years. One reason for this will be technological advances that facilitate the automated extraction, aggregation and filtering of news57. Such news analytics, discussed in Chapter 2, could be used in model

construction for high frequency traders, as well as for portfolio managers. News analytics technologies currently allow for the electronic ‘tagging’ of news events, corporate filings and the like, allowing traders with access to this computer technology the ability to see more information faster. Tying such information into CBT strategies provides a means for traders to capitalise on information before it is incorporated into market prices. High frequency traders will be well positioned to take advantage of such nascent technology.

To the extent that such trading puts information into prices more rapidly, markets will benefit by becoming more efficient. However, such strategies also serve to increase the ‘arms race’ in markets by bestowing greater rewards on the most technologically advanced traders. Consequently, it may be that all trading evolves towards CBT, reflecting the fact that technology diffuses across populations given time.

As this happens, market systems may experience unwanted negative effects. One such effect is already present in the problems of message traffic. Message traffic is the name given to computer instructions to place, change and cancel orders. On any trading day, message traffic far exceeds trading volume, as many more orders are cancelled or changed than are ever executed. On volatile days, message traffic can cause market outages due to the inability of servers and other computer components of trading to handle the flow. Such outages were widespread during the Flash Crash of 6 May 2010. They recurred in early August 2011, when the extreme volume and volatility took out trading platforms at Goldman Sachs and other large trading firms in the USA. When this occurs, market liquidity is affected58_.

A related systematic risk can arise if a large sub-set of market participants are following the same strategies. For example, if news analytics becomes a driving force in portfolio management, then sequences of sell (or buy) orders may arrive at the market, all driven by the same information. For market makers, such orders are ‘toxic’, because the market maker will be acting as counterparty to agents with better information. As seen in the Flash Crash, when toxicity overwhelms market makers their strategy is to withdraw, and illiquidity results. Consequently, new risk management products will need to evolve to allow market makers, traders and regulators to be able to function59_{. The future of}

CBT may thus involve more technology capable of controlling the technology controlling the markets. Finally, it is not possible to legislate market crashes away, any more than it is possible to dispense with the business cycle. In future crises, regulators need to be able to reconstruct what has happened; when, where and why. One of the consequences of MiFID was the loosening of the trade reporting protocols in Europe so that trades can be reported through Trade Reporting Facilities (TRF) other than the ‘primary’ market. This made ex-post auditing work much more difficult than it is in the USA where they have had a consolidated tape for some time. Europe is somewhat behind in the collection, standardisation and analysis of financial data in comparison to the USA, where the Office of Financial Research (OFR) has been commissioned by the Dodd-Frank Act to found a financial data centre to collect, standardise and analyse such data60_.

57 See DR8 (Annex D refers).

58 At the time of writing, many exchanges, including the LSE, have introduced ‘message throttling’ as well as pricing systems which may mitigate some of these effects.

59 Easley et al. (2011b).

3.6 Conclusions

CBT is now the reality in asset markets. Technology has allowed new participants to enter, new trading methods to arise and even new market structures to evolve. Much of what has transpired in markets is for the good: liquidity has been enhanced, transactions costs have been lowered and market efficiency appears to be better, or certainly no worse. The scale of improvements may be fairly small and, in the short term, they may have been obscured by the background of a very poor performance by

Organisation for Economic Co-operation and Development (OECD) economies and stock market indexes in particular. However, there are issues with respect to periodic illiquidity, new forms of manipulation and potential threats to market stability due to errant algorithms or excessive message traffic that must be addressed. Regulatory changes in practices and policies will be needed to catch up to the new realities of trading in asset markets. Caution must be exercised to avoid undoing the many advantages that the high frequency world has brought. Technology will continue to affect asset markets in the future, particularly as it relates to the ultra-fast processing of news into asset prices.

4 Financial stability and