FCA publishes paper indicating HFTs do not prey on other market participants

The UK Financial Conduct Authority (FCA) today published an Occasional Paper, dedicated to high-frequency trading (HFT) and examining whether high-frequency traders (HFTs) prey on other market participants.

The paper, authored by Matteo Aquilina and Carla Ysusi, both working in the Chief Economist’s Department of the Financial Conduct Authority, examines claims that HFTs can predict when orders are going to arrive at different trading venues and trade in advance of slower traders by exploiting their speed advantage. These claims imply that HFTs can generate profits without taking risks thanks to their latency advantages.

  • Data and subjects

The study uses a novel dataset with full order-book data on 120 stocks traded on lit venues in the UK for the year 2013.

The data include all the information recorded by the matching engine of three UK trading venues at the millisecond level. The trading venues covered are the London Stock Exchange (LSE), BATS, and Chi-X. These venues account for approximately 85% of all FTSE on- exchange traded volume in the UK. The one major UK venue that is not part of the dataset is Turquoise, which accounts for the bulk of the remaining 15% of traded volume.

The sample is made up of 60 stocks from the FTSE 100 and 60 stocks from the FTSE 250 index.

The study observes 26 direct members of the trading venues that are classified as HFTs.

  • Two questions

The paper investigates two related questions:

  1. Firstly, whether HFTs exploit their small (milliseconds) latency advantages to anticipate orders arriving in very quick succession at different trading venues from other market participants.
  2. Secondly, whether HFTs can anticipate the order flow over longer timeframes (seconds or tens of seconds).
  • Key findings

The study did not find evidence that the first behaviour is occurring systematically: there is no evidence in the sample that HFTs can “see the true market” and trade in front of other participants at a millisecond frequency.

This may be attributed to the regulatory set-up in the UK. In the UK, in contrast to the US where allegations originally emerged, there is no requirement for an order to be routed according to the best available price on every venue (the “order protection rule” in the US), and brokers are free to use routing strategies that cannot easily be predicted. Also, the short distance that separates the UK trading venues (which are all located within a few miles of each other in the vicinity of London), makes being faster than other participants less advantageous than in the US.

HFTs could be predicting the flow over longer time periods. When moving from very short periods (milliseconds) to longer durations (seconds or tens of seconds), the study finds patterns consistent with HFTs anticipating the order flow. However, the authors of the study are not certain whether this is due to HFTs reacting more rapidly to new information, or to order-flow anticipation.

The results of this paper are only valid for the specific HFT strategies that it investigates. It does not draw any conclusions on whether strategies different from those analysed in this study are employed by HFTs and other market participants in the UK market and whether or not they are detrimental for the quality and integrity of UK markets.

The paper is available to download from this page.

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