Are High-Frequency Traders Anticipating the Order Flow? (By the FCA)
High-frequency traders (HFTs) have received a mixed reaction from academics and practitioners with some people underlining their role as liquidity providers and others highlighting the problems that they could bring to the market. A specific allegation that has been made is that by exploiting their speed advantage, HFTs can predict when orders are going to arrive at different trading venues and trade in advance of slower traders. Using order book data from the UK equity market, we investigated this specific allegation by looking for patterns compatible with HFTs anticipating the order flow of other participants on lit venues. We do not find evidence that HFTs systematically anticipate near-simultaneous marketable orders sent to different trading venues by pure non-HFTs. But when analysing longer time periods (measured in seconds or tens of seconds), we do find patterns consistent with HFTs anticipating the order flow of pure non-HFTs. However, we cannot say whether this is due to HFTs reacting more rapidly to new information, or to order-flow anticipation.
We have published this Occasional Paper alongside an article New analysis offers mixed picture on high frequency trading in the UK.
Since they started participating in financial markets, High Frequency Traders (HFTs) have received a mixed reaction from academics and practitioners, with some underlining their role as liquidity providers and others highlighting the problems that they could bring to the market. A specific allegation that has been made is that HFTs prey on other market participants and only intermediate trades that would have taken place without their involvement. There are 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 infer that HFTs can make profits without taking risks due to their latency advantages.
In this paper, we investigate whether there is evidence that this behaviour is taking place on a systematic basis. We use a novel dataset with full order-book data on 120 stocks traded on lit venues in the UK for the year 2013.
We investigate two closely related questions. 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. Secondly, whether HFTs can anticipate the order flow over longer timeframes (seconds or tens of seconds). We do not find evidence that the first behaviour is occurring systematically: there is no evidence in our sample that HFTs can ‘see the true market’ and trade in front of other participants at a millisecond frequency. This could be due to the physical characteristics of the UK market. As all the trading venues are within a few miles of each other, in the vicinity of London, it takes a very short time for messages to go from one venue to the other (microseconds). Further, the regulatory set-up makes it more difficult to predict where orders will be routed, compared to the US market.
We do find patterns consistent with HFTs being able to anticipate the order flow over longer time periods (seconds and tens of seconds). This is particularly true for those market participants that adopt ‘pure’ non-HFT strategies (i.e. those participants that do not use low-latency technology). However, we cannot say whether this is due to HFTs reacting more rapidly to new information, or to order-flow anticipation. Furthermore, when looking at specific non-HFTs (something that market participants themselves cannot do as the orders they see are anonymous), we find evidence that a number of them send some of their orders in a somewhat predictable way, by sending them a few milliseconds apart on a regular basis.
It is not simple to assess the implications of anticipatory behaviour for society as a whole: this behaviour may or may not be detrimental depending on very specific characteristics of the order flow. Also, although it is often attributed to HFTs, other market participants, such as investment banks (if they use the appropriate technology and/or manage to sufficiently reduce their latency), may also engage in these behaviours.
The results of this paper are only valid for the specific HFT strategies that we investigate. We do 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.
Matteo Aquilina and Carla Ysusi.
Matteo Aquilina and Carla Ysusi work in the Chief Economist’s Department of the Financial Conduct Authority.
Occasional Papers contribute to the work of the FCA by providing rigorous research results and stimulating debate. While they may not necessarily represent the position of the FCA, they are one source of evidence that the FCA may use while discharging its functions and to inform its views. The FCA endeavours to ensure that research outputs are correct, through checks including independent referee reports, but the nature of such research and choice of research methods is a matter for the authors using their expert judgement. To the extent that Occasional Papers contain any errors or omissions, they should be attributed to the individual authors, rather than to the FCA.
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