Barriers to Market
Quality
Barriers to Market Quality - The HFT Behaviors
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The SEC breaks HFT behaviors down into four strategies1
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Market Making: like traditional market making, this strategy attempts to make money by
providing liquidity on both sides of the book and earning the spread (along with rebates from
posting)
Arbitrage: trading when arbitrage opportunities arise (e.g. mispricing between Indices, ETFs
or other instruments and underlying constituents)
Structural: strategies seek to take advantage of any structural ‘vulnerabilities’ of the market
or certain participants, and include latency arbitrage or quote stuffing
Directional: these strategies attempt to get ahead of – or trigger – a price move, and include
order anticipation and momentum ignition
While market making and arbitrage “may be beneficial” to markets, they mask the
negative impact of other HFT strategies2, typically qualified as Predatory HFT Strategies
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Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
Order Book Fade: lightning-fast reactions to news and order book pressure lead to
disappearing liquidity
Momentum Ignition / Exploratory Trading: an HFT trader detects a large order targeting a
percentage of volume, and front-runs it.3 4
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Concept Release on Equity Market Structure. SEC, 2010
Credit Suisse – AES Analysis, December 2012
Exploratory Trading – Adam D. Clark-Joseph, January 2013
Do HFTs anticipate buying and selling pressures – Nicholas Hirschey, December 2011
Barriers to Market Quality - Impact of HFT Behaviors
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Predatory HFT Behaviors
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“Beneficial” HFT Behaviors (or Opportunistic?)
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Increase intra-day volatility representing a tax on investors
Impair price formation by exacerbating volatility
Distort price discovery by manipulating true supply and causing market data issues
Amplified by a herd-like behavior1
HFT market making is typically opportunistic and limited to large stocks (sparse in small and
medium cap stocks), furthermore it declines on less active and less volatile days2
The combination of Predatory and Opportunistic HFT Behaviors leads to
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Negative impact on the sustainability of Designated Market Makers (with obligations) who
must participate in many undesirable trades and bear substantial inventory risks and capital
costs
Negative impact on liquidity of small and medium cap securities and securities in general on
days of true market stress
Larger volumes, resulting from over-intermediation, that lead marketplaces to support HFTs
and further enable their strategies through fee strategies, co-location services, ultra lowspeed data feed, etc
1. A Dysfunctional Role of High Frequency Trading in Electronic Markets – Jarrow & Protter, March 2011
2. Should Exchanges impose Market Maker obligations – Anand & Venkataraman, November 2012
Barriers to Market Quality
What is the Academic Research telling us about HFTs?
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Research on HFTs’ impact on markets is prolific and can be characterized as follows:
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Lacks access to complete, reliable and granular data (the HOT Study being an exception)
Biased conclusions (usually aligned with the interests of the sponsor/data provider)1
Uses decades old methodologies ill suited to fairly examining today’s market structure:
• Periodic snapshots of prices fail to capture the full price path of today’s high velocity
market
• Use of mid-point pricing is a decades old technique used to compensate for market
structure nuances (bid-ask bounce) in thinly traded markets
• Cite volume and spread improvements while it is well known to practitioners that
access to displayed liquidity is highly problematic and volume is driven by significant
intermediation
Analysis needs to be performed in a more granular way to identify what is truly
happening in the markets2
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2.
See Summary of Academic Papers in HOT Study
Credit Suisse – AES Analysis, December 2012
Aequitas’ Safe Haven
Preventing Predatory and Opportunistic HFT Strategies
Predatory HFT Strategy
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Aqeuitas Response
Quote Stuffing
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Description
Flooding the market with orders and cancellations leading to
a large number of new best bid / asks potentially lasting
microsecond
Objectives
 Walk someone in the book / leverage rebates
 Create false mid-points
 Cause stale prices & slow market data impacting others
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Layering
Quote Stuffing
Segmentation, Matching Priorities and Fees
 Quote Stuffing only works when the party initiating it can
subsequently trade under following conditions:
counterparty is natural flow, speed advantage allows Top
of Book position, rebates available
 Dark and Lux, where aggressive natural flow is expected
to concentrate, negatively impacts these conditions:
pegged orders, market maker and size priorities, no
rebates but fees for resting orders
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Layering
Description
Segmentation and Matching Priorities
Placing numerous orders (buy / sell) at different price points  Market makers and natural liquidity providers are
to give an impression of strong buying / selling pressure or
protected from aggressive HFT strategies by a speed bump
to pre-position in support of other strategies
in the Lux Book which will curtail signalling strategies on
other venues
Objectives
 Matching priorities in various Aequitas Books will curtail
 Drive price up/down to sell expensive / buy cheap and
benefits of layering to pre-position orders
trade out when the book reverts
Fees
 Pre-position orders to take advantage of momentumignition strategy or rebates
 Rebate strategies are not enabled in Dark and Lux
Aequitas’ Safe Haven
Preventing Predatory and Opportunistic HFT Strategies
Predatory HFT Strategy
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Aqeuitas Response
Book Fade
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Description
Volume disappearing on a specific venue or other venues
after a trade on a specific venue
Objectives
 Avoid and/or pass on (switching to active) adverse
selection when not actually intending to trade at a certain
price (often combined with layering strategy)
 Leverage latency arbitration amongst venues
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Momentum Ignition
Description
Triggering other participants to trade quickly and cause a
rapid price move
Objectives
Taking a profit after having taken a pre-position or by
layering the book knowing the price is likely to revert and
trading out afterwards
Book Fade
Segmentation and Matching Priorities
 Speed bump in Lux will make it more difficult for HFT
firms to pass on adverse selection
 Matching priorities in various Aequitas Books will curtail
benefits of layering to pre-position orders
Smart Order Router
 Latency normalization across all venues
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Momentum Ignition
Segmentation and Matching Priorities
 Dark Book will not allow for such strategies
 Market makers and natural liquidity providers are
protected from aggressive HFT strategies by a speed bump
in the Lux Book which will curtail signaling strategies on
other venues
 Matching priorities in various Aequitas Books will curtail
benefits of layering to pre-position orders
Aequitas’ Safe Haven
Preventing Predatory and Opportunistic HFT Strategies
Predatory HFT Strategy
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Exploratory Trading
Description
Sending in small aggressive orders to obtain private
information to forecast the price impact of predictable
demand
Objectives
 Trading ahead of predictable demand only when it is
profitable to do so
Opportunistic HFT Strategy
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Market Making when it is profitable
Aqeuitas Response
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Exploratory Trading
Segmentation
 True liquidity in Dark can not be tested
 Speed bump in Lux and high active fees will curtail these
types of strategies
Predatory HFT Strategy
•Market Making when it is profitable
Description
Matching Priorities
Provision of liquidity in large and liquid securities at the full
 Provide designated market makers with adequate
discretion of the HFT impacting sustainability of true market
compensation for their services by giving them execution
makers
priority
Objectives
Segmentation
 Generate earnings when profit opportunities are high and
inventory risk is low while minimizing cost of capital
 Protect designated market makers from Predatory HFT
Strategies with speed bump for aggressing flow in Lux