1. High-Frequency Trading and Price Discovery Terrence Hendershott (Jonathan Brogaard Ryan Riordan)

2. Overview Technology has been good for markets
Is every use of technology good?
How do we think about (evaluate) HFT?
What are costs/benefits of those closest to the market?
Analysis of Nasdaq HFT data in terms of price discovery
Statistical model of HFT and “information” and “noise” in prices
Challenges in interpreting these results
Cross-correlations between HFT and price changes
Explore what types of information HFT has (not in paper yet):
Macro news announcements
Market-level (as opposed to individual stocks) results
Limit order book imbalances
High-Frequency Trading and Price Discovery

3. The old trading floor, NYSE 1873

4. More recent trading floor
High-Frequency Trading and Price Discovery

5. Current trading floor Securities Market
Algorithmic & High-Frequency Traders/Systems
Algorithmic and High-Frequency Trading
Algo Trade Definition: “The use of computer algorithms to manage the trading process.‘‘
(Hendershott et al. 2011); HFT similar, but for short holding periods
High-Frequency Trading and Price Discovery

6. Is the evolution good? Some News Articles
“...rule changes are need to control risks...”
“…development have had negative effects…”
“HFT firms are accused of flooding markets with orders that are cancelled…, leading to volatility”
Ultra fast trading needs curbs – global regulators
July 7, London
“...the stock market is more prone than ever to large intraday moves with little or no fundamental catalyst.”
“locusts … feeding off the equity market.”
It's hard to imagine a better illustration (of social uselessness) than high-frequency trading. The stock market is supposed to allocate capital to its most productive uses, for example by helping companies with good ideas raise money. But it's hard to see how traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve that social function.
Paul Krugman August 2, New York Times
“High-frequency traders generated about $21 billion in profits last year.”
“...use rapid-fire computers to essentially force slower investors to give up profits, then disappear before anyone knows what happened. ”

7. Longer perspective on technological changes affecting liquidity
Technological advances have made the markets better:
Evidence from trends and specific events/introduction
High-Frequency Trading and Price Discovery

8. Liquidity (Trading Costs/Spreads) on NYSE
Decline is from lower averse selection (less information in trading) -- Hendershott et al. 2011
How well can we measure liquidity as trade size -> 0? Transitory impact of large orders?
High-Frequency Trading and Price Discovery

9. Algorithmic Trading on NYSE
Hendershott et al. 2011
High-Frequency Trading and Price Discovery

10. Correlation is not causality: we need a “natural experiment”: Autoquote
High-Frequency Trading and Price Discovery

11. Algo Trading is a superset of HFT What is HFT?
HFT is always AT – but AT is not always HFT
Typical properties of HFT:
High-speed trading
Sophisticated computer programs
Use of co-location services and data feeds
Short time frames for establishing and liquidating positions, high trading volume and intensity
(SEC, , Concept Release on Equity Market Structure)
HFT is a mixture of the use of technology and trading strategies (do they differ?)
What is new is direct access, increased electronic information sources, and more computing
High-Frequency Trading and Price Discovery

12. HFT Strategies (SEC)
Anything new here?
Short-lived strategies with tight risk management
Based on public information, technology, and sophisticated tools
Is the focus the technology, strategies, or interaction?
Passive Market Making
Arbitrage
Structural
Directional
Strategies
Cross asset and cross market arbitrage
Statistical arbitrage
Make money at the bid-ask spread and liquidity rebates
News Trading
Liquidity Detection (order anticipation)
Momentum trading and ignition
Latency Arbitrage
Flash orders
Problematic strategies
High-Frequency Trading and Price Discovery
Prof. Dr. Max Mustermann | Name of Faculty

13. HFT and Price Discovery (beyond liquidity)
United Airlines files for Ch. 11 to cut costs - Bloomberg
United Airlines Share Price
Sept. 19th, 2002
Sept. 6th, 2008
10:58 Sept. 8th, 2008
Sept. 8th, 2008
High-Frequency Trading and Price Discovery

14. Price Discovery: Efficient Price & Noise
Explicitly model observed prices each minute as efficient price (martingale) and noise (pricing error)
Observed price is martingale (efficient price) plus noise:
Trading makes cov(s,w) <> 0
Standard market microstructure approach: Innovations in martingale are related to innovations in trading:
Transitory component also relates to trading:
Identification from Cov(m,u)=0 (Hasbrouck (1993) and others)
High-Frequency Trading and Price Discovery

15. Price Discovery: Interpretation
k trading’s (order flow) relation to efficient price
+ informed about change in efficient price
- adversely selected on efficient price
y trading’s (order flow) relation to noise
+ direction of trading correlates with more noise
Transitory price impact, risk mgt., manipulation, order anticipation
- trading against noise, making prices more efficient
Statistical arbitrage via identifying transitory effects
Decompose overall HFT order flow into Liquidity Demand and Supply
Examine highest volatility days (stability?)
High-Frequency Trading and Price Discovery

16. Nasdaq HFT Data 120 stocks: small, medium, large cap
Identifies 26 independent HFT firms
Via unique “port” which firms use
Does not identify large integrated firms, e.g., Goldman
All data is aggregate across all HFT firms
Is this a representative sample? If not, why not?
HFT firms worried about regulatory response
Data is available via NDA with Nasdaq
Nasdaq had 20-40% market share
HFT is 42% of volume in large stock, 12% in small stocks
Market/limit order volume similar in large, less limit in small
High-Frequency Trading and Price Discovery

17. Nasdaq HFT (SSM) Price Discovery Results
Overall HFT trade to make prices more efficient
Results remain (and are stronger) on high-volatility days
Market order trading is responsible for this
+ correlation with efficient price, - with pricing error/noise
Consistent with forecasting both parts of returns
Limit order trading coefficients have opposite signs
- correlation with efficient price, + with pricing error/noise
Efficient price: standard adverse selection of liquidity providers
Noise: risk mgt., adverse selection, manipulation, order anticipation?
Do these passive trades make money?
Yes, earn the spread and liquidity rebates
Overall HFT profitability per $ is low: ~$0.03/$10,000 traded
High-Frequency Trading and Price Discovery

18. Interpretation of Statistical Model
Is HFT being informed good or bad?
HFT liquidity demand imposes adverse selection
But, also trade against noise in prices
It is possible to do one without the other?
How important is this information? How long-lived?
Would it get into price anyway?
HFT liquidity supply looks a lot like market making (good)
How could we measure excess intermediation (bad)?
Next, cross-correlations for individual stocks and market-wide and macro news announcements
High-Frequency Trading and Price Discovery

19. Individual Stocks: HFT and Future Stock Returns (1sec periods)
HFT Demand positively predict stock returns for a few seconds
HFT Supply negatively predict stock returns for a few seconds
Demand effect dominates overall
High-Frequency Trading and Price Discovery

20. Event Study: Macro Announcements
Aligning return and HFT times is challenge (Nasdaq BBO for subset)
HFT Supply is adversely selected; HFT Demand is transmitting info
Overall Supply dominates; how to think about this HFT Demand?
Regressions show HFT Demand is not associated with noise
High-Frequency Trading and Price Discovery

21. Event Study: Macro Announcements
Similar to Negative announcements
Predominantly HFT is providing liquidity at most stressful time
209 Announcements in: Construction Spending, Consumer Confidence, Existing Home Sales, Factory Orders, ISM Manufacturing, ISM Services, Leading Indicators, Wholesale Inventories
High-Frequency Trading and Price Discovery

22. Market-wide: HFT and Future Stock Returns (1sec periods)
HFT Demand positively predict market-wide returns for a few seconds
HFT Supply negatively predict market-wide returns for a few seconds
Supply effect dominates overall (also true in a market-level SSM)
Past market returns predict HFT similarly (E-mini predicts HFT Demand)
HFT has a longer lasting role in market-wide price discovery
High-Frequency Trading and Price Discovery

23. Another source of HFT Information
Limit order book imbalance LOBI (Size at offer minus Size at bid)
LOBI predicts future returns (-), HFT Demand (-), HFT Supply (+)
Not much in the small stocks
High-Frequency Trading and Price Discovery

24. Sources of HFT Information
Other sources of “Public” information in past prices, orders?
In other assets (market-wide, announcement results)
Large stock leading small stocks
HFT Demand predicts returns
How to think about short-lived nature of (public) information?
Foucault, Hombert, and Rosu (2012)
Reducing the transitory part is good
Trading on (soon to be) public information is not
How do we know what information will get into price without HFT?
High-Frequency Trading and Price Discovery

25. Conclusions/Thoughts
Technology has improved markets
Algorithms: prices more efficient and markets more liquid
HFT is technology applied to certain strategies
Make prices more efficient; true on high-volatility days also
What are the benefits of getting info into prices in seconds?
Does this improve financing and investment decisions?
Should traders closest to the market mechanism be informed?
Focus attention on HFT liquidity demanding strategies?
Are long-term investors losing out (zero sum trading)?
If so, will HFT become competitive and offer technology services to long-term investors?
Will market structures evolve to support LFT (without HFT)?
What is the optimal configuration of intermediation sector?
Free entry or regulated monopoly/oligopoly?
Specific regulations on liquidity supply and demand?
High-Frequency Trading and Price Discovery