Market Structure and Regulatory Changes in HFT

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Market Structure and Regulatory Changes in High-Frequency Trading

Around the world a number of laws have been implemented to discourage activities which may be detrimental to financial markets. There has been an active debate going on some of these changes to ascertain whether these changes can be detrimental to the market itself. Some experts have been arguing that some of the regulations targeted at HFT activities would not be beneficial to the market. They state that on one hand we have high-frequency traders acting as market makers who have order-flow driven information and speed advantages and on the other hand we have traders who are not sensitive to the latency as such and often arrive randomly as a Poisson process. Empirical results in general suggest that these regulations targeted towards HFT do not necessarily improve market quality as they fail to offer sufficient evidence pertaining to sudden market failures such as the Flash Crash.

Financial Transaction Taxes

Financial Transaction Taxes

Some member states of the EU and EU itself have already started collecting or planning on collecting a financial transaction tax (FTT). Tax revenues can be increased by compelling the financial sector to make a fair and substantial contribution toward paying for any burden associated with government interventions to repair the banking system. FTT can also be used to limit HFT related excessive trading which would lead to a revenue increase for the government. At the right level, FTT could pare back HFT without undermining other types of trading, including other forms of very rapid, high-speed trading. To curb short-termism associated with HFT, the Business, Innovation and Skills Committee of the United Kingdom recommends the British Government to evaluate suitability of a FTT on equities “at a level which is the average profit made on a High Frequency Trade” in the UK.

However levying of taxes on transactions is not new, the UK has been levying FTT in the form of stamp duty since 1964 with charges of 0.5% to the buyer of a stock. This helped the government to raise about five billion euros during 1999-2000. Those who oppose FTT strongly argue that that the taxing scheme is not adequate in counteracting speculative trading activities. Due to the lack of convincing evidence that FTTs reduce short-term volatility, FTTs are unlikely to reduce the risk of bubbles in future.

The Swedish FTT applied during 1984-1991 in the hope of raking in additional tax revenue and rein financial markets is a classic failure of FTT implementation. 50-basis-point tax on equity transactions levied by Sweden resulted in migration of more than half of equity trading volume from Sweden to London. This proved itself to be a poor source of revenue and an inadequate mechanism to regulate the equity market.

With all the scepticism in place, the EU proposed a continent-wide FTT with rates of 0.1% for shares and 0.01% for derivatives. From the 11 EU member states that are in favour of the legislation, it is expected to raise an additional 30 to 35 billion euros per year. It is also expected that the financial sector would be engaged in more responsible activities and geared towards the real economy.

In the USA, Congressman Peter DeFazio proposed bill titled ‘Let Wall Street Pay for the Restoration of Main Street Act of 2009’ this supposedly help fund job creation and deficit reduction. Tax of 0.25% of the value for stocks and of 0.02% of the value for futures and swaps would be levied while expecting to raise $150 billion in tax revenue.

Regulations on Excessive Order Submissions and Cancellations

Regulations on Excessive Order Submissions and Cancelations

Submission and cancellation of a large amount of orders in a very short amount of time are the most prominent characteristics of HFT. Charging a fee for high order-to-trade ratio traders has been considered to curb harmful behaviours of HFT firms. Slower traders can trade more actively if OTR tax is implemented while hindering manipulative activities, this would also improve liquidity in general.

By sending huge number of orders, one of the purpose of HFT is for providing liquidity while maintaining profitability, decreasing the orders would lead to decline in liquidity. After analyzing ten FTSE 100 stocks levying a cancellation fee on higher OTR traders will discourage competition across trading venues and result in decline in liquidity.

Since 2012 Borsa Italiana, Italy’s main stock exchange located in Milan, has been charging a fee to traders with OTR higher than 100:1 (0.01 euro per order), 500:1 (0.02), or 1000:1 (0.025).

While in France, OTR fee was implemented in the August of 2012 however market making, smart order routing, and automated execution of large orders were not subjected to the tax. The French OTR tax did not have any significant effect on market quality.

Before OTR was found in USA it was merged with BATS Global Markets in 2014. Members with average monthly OTR greater than 100 to 1 would have their rebate lowered by $0.0001 per share, to “protect markets from excessive message traffic in Message Efficiency Incentive Program introduced by Direct Edge in June 2012. As the exchange itself concluded that the program may have discouraged trading activities the program was rescinded within months.

The German HFT Act which was introduced in 2013 resulted in decline in the number of orders, with the number of executed trades exhibiting little change. HFT firms which were liquidity providers were the ones whose orders were reduced. The legislation did not have any significant effect on the market quality and the overall effect was negligible.

Rebate Structures

Some experts say High-frequency traders enjoy a hefty amount of profit from rebates. While limit order traders are compensated with rebates, market order traders are charged with fees thus providing liquidity to the market as traders, often HFTs, are sending the limit orders to make markets, which in turn provides for the liquidity on the exchange. It is attractive to traders who submit a massive number of limit orders since the pricing scheme provides less risk to limit order traders. This structure is being currently used by United Kingdom’s London Stock Exchange and the United States’ BATS BZX along with manyothers.

As per experts there also exists an opposite fee structure to market-taker pricing called trader-maker pricing it involves providing rebates to market order traders and charging fees to limit order traders is also used in certain markets. Such structures are less favorable to high-frequency traders in general and experts argue that these are often not very transparent markets, which can be detrimental for the markets.

Deutsche Boerse the German exchange offered fee rebate to algorithmic traders so that such traders become beneficial to trading volume and liquidity. To encourage automation of trades, the program financial supported technological investments to encourage automation of trades. When spreads are wider algorithmic traders supply liquidity while take the liquidity when the spreads are relatively narrow.

Monitoring of Trade Activities

Monitoring of Trade Activities

The MIFID 2 which is under proposal by the EU, requires algorithmic traders to report to relevant authorities

on the traders’ strategies, trading parameters or limits, key compliance, and risk controls. However it is expected to be fully functional by 2017, it mandates HFT traders to appropriately store records of all placed orders, including those that are cancelled, and have the records available to relevant authorities upon request. This would help the authorities devise a plan to reduce the risk of sudden market changes or disruptions caused by malfunctioning algorithms. This comes with an additional cost of analysing all HFT traders’ strategies, including examining

complex codes and software used. In the US SEC’s Rule 613 under Regulation NMS, it expects all exchanges to build a plan to – develop, implement, and maintain a consolidated audit trail that must collect and accurately identify every order, cancellation, modification, and trade execution for all exchange-listed equities and equity options.

Minimum Order Resting Times

To force all orders to stay in the market at least for some time minimum order resting times can be used since high-frequency traders to send and instantly cancel orders. A formal minimum order resting time might suppress the proliferation of ‘flickering orders,’ while providing assurances to market participants of available terms of trade. However as a consequence traders will be discouraged to submit limit orders given the inability to withdraw their orders before the required minimum resting time pass even when a material event arises. Hence if minimum order resting times are established market liquidity may decline.

NASDAQ OMX PSX used to offer the ‘minimum life orders’. The orders could not be cancelled within 100 milliseconds after submission, those who submit these orders were compensated by higher liquidity rebate at 0.0026 cent per share, compared to 0.0024 cent for basic orders. This order type is no longer available in the exchange.

Circuit Breakers

Circuit Breakers

In order to prevent extreme market volatilities circuit breakers are being used. To prevent market crash incidents like in October 1987, NYSE has introduced circuit breakers for the exchange. The circuit breaker pauses market-wide trading when stock prices fall below a threshold.

The market halts trading for 15 minutes if the Dow Jones Industrial Average and S&P 500 fall below certain thresholds according to a rule which governs the use of circuit breakers. The Limit Up/Limit Down (LULD) Plan sets price bands outside of which individual securities cannot be traded. The plan was approved by US SEC to address sudden price movements that the market experienced on the afternoon of May 6, 2010.

Structural Delays in Order Processing

A random delay in processing of orders by certain milliseconds has been proposed implementation to counteract some HFT strategies which supposedly tends to create an environment of technology arms race and the winner-takes-all. The advantage of faster traders declines significantly under random delays, while traders may still have motivations to improve their trading speed. The benefits of improving trading speeds would diminish tremendously; this would discourage HFT traders to engage in fruitless arms race.

Frequent batch auctions design has also been proposed to discourage the technology arms race. Orders submitted by faster traders may be treated concurrently with those by slower traders, hence reducing the benefit of marginal superiority in speed.


The landscape of stock market trading has changed drastically. High-powered computers running sophisticated software are handling transactions. Decisions to buy and sell based on preset parameters are made by computers controlled by professional traders. By taking various regulatory initiatives market regulators around the world have been trying to keep up with the high-speed evolving environment of automated trading.

In the high-frequency trading era there have been a number of aberrant stock market behaviors. However empirical evidence suggests that high-frequency trading tends to improve market quality in general.

Next Step

If you’re a retail trader or a tech professional and want to learn high frequency trading, begin with basic concepts like high frequency trading architecture, history of HFT, market microstructure, MiFID-II, HFT’s impact on market quality and order management system.

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