First of all, I would like to thank my thesis advisor Dr. Bonnie Van Ness for her countless hours and guidance that helped me complete the writing of this dissertation. REGULATORY IMPACT ON THE US AND EUROPEAN FINANCIAL MARKETS. led by Bonnie Van Ness). High-frequency trading has impacted the US and European financial markets due to its sophisticated algorithms, high speed and preferential treatment in purchasing information and co-location through exchanges.
Through my research, I have discovered that previous regulations implemented by US and European regulators have benefited high-frequency trading firms, and that exchanges, by selling information through co-location, have created an environment that benefits high-frequency traders . High-frequency trading firms negatively influence the market by providing a false sense of liquidity while acting as market makers and purchasing preferential information and access to the financial markets.
INTRODUCTION
High-frequency trading firms rarely hold positions overnight and work more as market makers than traders (Patterson, 2012). High-frequency trading companies differ from traditional market makers in that they are not regulated and registered as market makers, they operate freely and without the knowledge of most traders (Lewis, 2014). That high-frequency trading is complex and difficult to understand is something most people who have heard of it agree on.
In this dissertation I will discuss how high-frequency trading affects the legal and economic domains in America and Europe. High-frequency trading affects a country's economy by the way it affects the confidence of ordinary investors.
HIGH FREQUENCY TRADING
- U.S. STOCK MARKET HISTORY
- ALGORITHMIC TRADING
- HIGH FREQUENCY TRADING HISTORY
- HIGH FREQUENCY TRADING METHODS
- HIGH FREQEUNCY TRADING ORIGINS
- DARK POOLS
Due to the regulation, high frequency trading started to grow even more and in 2009 high frequency traders had 70% of the market (Arnuk & Saluzzi, 2012). High-frequency trading works in different ways depending on the type of high-frequency trading and the goals of the high-frequency trader. The basic concept of high frequency trading is to use a network of computers located at the various exchanges to trade.
This is why it took so long for the market to discover what high frequency traders were doing. High frequency trading companies simply trade ahead of orders and slightly increase the price or trade in a different location. Other tactics used by high-frequency traders are quote stuffing, spoofing, and momentum ignition (Gregoriou, 2015).
An example of high frequency traders accessing dark pools happened in 2011 with Pipeline.
THE IMPACT OF HIGH FREQUENCY TRADING ON THE STOCK
- LIQUIDITY PROBLEMS
- COST
- FLASH CRASH
- HIGH FREQUENCY TRADING BENEFITS
Therefore, high-frequency traders enjoy special privileges, as they submit a large volume of orders to exchanges (Arnuk & Saluzzi, 2012). Another privilege paid by high-frequency traders, which is also a problem for the regular investor, is. At the same time that high-frequency trading firms make more money because they trade faster, so do the stock markets.
Gregoriou discusses an example where a high-frequency trading firm bought access to the financial report of a company called ULTA. Another topic discussed is whether or not high-frequency traders provide liquidity to the market. High-frequency traders buy and sell large amounts of stocks every day, as long as the markets are in their favor.
In a recession, high-frequency traders do not provide liquidity, but take and demand what little liquidity is still in the market. Opportunity liquidity currently accounts for 80% of the market and is the category of liquidity provided by high-frequency traders. The reason liquidity has disappeared is because the “liquidity” provided by high-frequency traders is only provided when markets are normal (Gregoriou, 2015).
When markets begin to shift and volatility increases, high-frequency traders "take" the liquidity. However, Gregoriou fails to mention what happens to the traditional market makers when unregulated high-frequency traders take their place. As described earlier in the thesis, high-frequency traders provide a false form of liquidity that is only beneficial when markets are running smoothly.
CURRENT REGULATIONS REGARDING HIGH FREQUENCY
U.S. MARKET
All Reg NMS has done is to give the illusion of liquidity to the market (Pandey & Wu). According to Arnuk and Saluzzi, one flaw in Reg NMS is the lack of a minimum spread or price increase. When prices moved from $1/8 and $1/16 to decimals, it became easier for high-frequency traders to step in ahead of others' orders, as it only took a penny to do so.
Reg NMS also stipulated that an order to buy or sell a share must be directed to the place with the best published price. So, a large order would most likely be partially executed on multiple exchanges, as by law the order had to be directed to the best price spot, even if the depth at the best price was not sufficient to cover the order. Because high-frequency traders were the fastest traders in the markets, they could detect a large order, trade before a partially filled order, immediately place an order at a slightly improved price (in other words, become the next best price) to then trade with.
Further, Reg NMS also put many market makers dealing in small and midcap stocks out of business due to margin compression (Arnuk & Saluzzi, 2012). High-frequency traders, with a large volume of order submissions, took the place of traditional market makers, but without the corresponding rules and regulations. When liquidity was low, high-frequency traders pulled out of the markets, reducing liquidity even more.
Average trade size decreased with high frequency traders (in conjunction with Reg NMS) as large orders from exchange to exchange had to be partially filled at each best price. Partial execution at the best price allowed high frequency trader to preempt partially filled orders and grab a share of the profits. One thing is certain and that is if not for these regulations, high frequency trading would not be what it is today (Arnuk & . Saluzzi, 2012).
LULD PLAN
Reg. (Arnuk & Saluzzi, p. 202).
EUROPE/SWEDEN
Finally, MiFID II states that the regulated European markets must conduct tests of existing algorithms in their markets and limit the ratio of unexecuted orders. As a result of these regulations, it will be easier to detect the system capacity that is strained, and MiFID II will help the regulated European markets to slow down the order flow if the system capacity is strained (Gregoriou). The regulated European markets must also ensure that there are no incentives to encourage disorderly trading or market abuse.
A canceled order fee will hinder high-frequency traders who place large quantities of orders that are in effect for less than one second. According to Gregoriou, regulated European markets may also have to impose even higher fees on high-frequency traders who continually cancel orders and hold them for short periods, which would further hurt the traders who are putting pressure on the financial system. The same problem that occurs in the US markets, where investors lose confidence in the markets, also occurs in the Swedish market.
When high-frequency traders can trade at high speed and in such large quantities, investors have no method to keep up with that competition, nor do investors have enough money to buy fast trading computers (Finansliv, 2015). Finansliv.se interviewed Per H Börjesson, CEO of Investment AB Spiltan, Börjesson believes that if this trend of high-frequency traders taking over the market and receiving preferential treatment within the exchanges continues, investors will leave the markets. This is a trend discussed earlier in this article that is also occurring in the United States.
When investors lose faith in the market, with no hope of regaining it, they stop investing. As has been emphasized earlier in this thesis, high-frequency traders are not long-term investors who buy the stock because they have analyzed the company and want to share in the company's future - both the profits and the risk associated with stock ownership. According to Hagström, high-frequency traders don't care what they buy, they buy these shares on the Swedish stock exchange only to make easy money.
HIGH FREQUENCY TRADING: THOSE TO BLAME
Most trading venues allow high-frequency traders to purchase preferential access to the venue through co-location. The debate about the harm or help to market quality that high-frequency trading brings continues. More regulations have been implemented in Europe to regulate high-frequency trading than have been implemented in America.
Thus, the EU standardized the rules dealing with high-frequency trading through MiFID II. Gregoriou (2015) notes that banning high-frequency trading will not solve the problem or help the markets. As high-frequency traders have assumed the role of market-making, they have become ultimately important to the future success of stock exchanges.
As explained earlier in this thesis, high frequency traders have taken over the market maker role. Due to the rules implemented by the SEC, such as Reg ATS and Reg NMS, high frequency trading has grown and flourished. However, proper regulations must be implemented to deal with the complexity that high-frequency trading brings.
European regulatory agencies have come a long way in addressing high-frequency trading with MiFID II. High frequency traders do not destroy the markets and it is not dangerous to invest your money in the market. Broken Markets: How High-Frequency Trading and Predatory Wall Street Practices Are Destroying Investor Confidence and Your Portfolio.
High-frequency trading: should technological developments be considered a potential threat to financial markets and subject to special regulation? Retrieved from http://www.bloombergview.com/articles why-do-high-frequency-traders-cancel-so-many-orders-.
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