HFT Impact Assessed

Terry Flanagan

The evolution of high-frequency trading has caught the attention of regulators, who are studying the impacts that HFT has had on markets as a prelude to issuing policy recommendations.

The Investment Industry Regulatory Organization of Canada (IIROC) is conducting a three-phase study of the impact of HFT on Canadian equity marketplaces.

IIROC published the first two phases of the study, known as the High Order to Trade (HOT) study, which objectively identified a study group of traders and offered a detailed, statistical analysis of their activity.

The HOT Study found that 11% of all traders were HOT traders and that this group accounted for 22% of the total share volume traded in Canada and 94% of order messages. The study also found that HOT traders were responsible for 36% of Canadian share volume traded in US inter-listed securities.

For the third phase of the study, IIROC is seeking input in the area of market structure, in order to assess the impact of HFT and related activity on Canadian market quality and integrity from multiple perspectives.

The HOT Study classifies 32 percent of its HOT sample as “fast,” 12 percent as “slow,” and percent as “inconclusive.” However, the fast traders that are most likely to be HF traders (those with direct market access) accounted for 84 percent of trading by volume, 87 percent by value, and 90 percent by number of trades.

“HFT enhances market quality,” said Jeffrey MacIntosh, professor of law at the University of Toronto and a director of CNSC Markets. “It lowers bid/ask spreads, reduces volatility, improves short-term price discovery, and helps create competitive pressures that reduce broker commissions. Retail traders, despite being at a speed disadvantage, realize a net gain from HF trading in the world’s capital markets.”

A report by Norges Bank Investment Management (NBIM) says that further regulation needs to take into consideration the impact of HFT on market quality as well as on market participants’ demands across the board – from retail to institutional. “We do not believe that HFTs just spontaneously emerged,” the report concludes. “Technological and regulatory changes were enablers, but it is also the change in the mix of market participants that created new profit opportunity niches that HFTs exploit.”

MacIntosh has explored the empirical evidence relating to the effect of HFT on capital markets, and the policy issues that HFT raises, and has published his findings in a report.

Among his policy recommendations are to maintain the Order Protection Rule and contain the spread of dark pools.

“To prevent abusive trading practices, protect client interests, and create a level playing field among different trading venues, policymakers should defend the consolidated order book by maintaining and policing the order protection rule and minimizing the leakage of trading from the ‘lit’ markets to ‘internalizers’ and dark pools,” MacIntosh said.

He also advocates retaining the maker/taker pricing model, which some critics say raises trading costs for retail traders. However, it is likely that much or all of the increased cost that results from being on the active side of the market has been absorbed by retail brokers, said MacIntosh. In addition, any increased cost that is passed on to the retail customer is more than made up for by lower bid/ask spreads on stocks.

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