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WHY SHOULD WE CARE ABOUT HIGH-FREQUENCY TRADING WHEN THE MARKET EXISTS FOR THE INVESTOR?

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WHY SHOULD WE CARE ABOUT HIGH-FREQUENCY TRADING WHEN THE MARKET EXISTS FOR THE INVESTOR?

Jonathan Seddon, Audencia Business School

For hundreds of years there were two players in the financial markets, the broker or low-frequency trader (LFT) working at the exchange and the investor. In 1964 an IBM computer introduced algorithmic trading on the New York Stock Exchange. This was to transform the way the markets would operate in the future.

Financial markets have always moved in cycles from boom to bust, bringing in changes in the way business is done. Perhaps the most significant changes have been witnessed following the 2008 financial crash. Prior to this the U.S. had spent two years rolling out Regulation National Market System (Reg. NMS), whilst in Europe Markets in Financial Instruments Directive (MiFID) had been legislated. The objective was to make the markets transparent by providing a structure to its fragmentation, ensuring the investor would view the market as fair and efficient. However this legislation opened the door for a third player – the high-frequency trader (HFT).  The market was then not inherently efficient and the LFTs were able to benefit from price differences (spread) as they provided liquidity in the search of a fair price. Today, HFTs provide most of this liquidity, operating at a much tighter spread and reducing the profits of other providers.

High-frequency trading is a subset of algorithmic trading, and the new legislation opened the door for it to dominate certain sectors of the market, in particular the equity and foreign exchange. Now in competition with other venues, the traditional exchanges looked for ways that they could attract liquidity. Whilst the LFTs had originally provided this, in return for not being charged trading fees, privileged physical position on the trading floor and limiting the number of LFTs offering each stock, this model no longer worked. Instead, exchanges now offered fees to those who could provide (mostly) liquidity to earn fees, but without any contractual obligations. Special order types were developed whose existence or use were not publicised (in 2015 Direct Edge were fined $14m for this). The fragmented market structure meant that those companies who could capture different prices for the same security could profit from arbitrage. Since 2007, HFTs have been engaged in technical battles to reduce latency – for example plans to build 300m tall microwave towers have been submitted in attempt to reduce milliseconds from the time between London and Frankfurt. Exchanges have also seen opportunities to sell co-location to their matching engines and data feeds to those companies who want to capture information as quickly as possible.

High-frequency tranding represents a paradigm shift in the way our markets operate. Unlike other investors, HFTs are not concerned with the profit opportunities in holding a company share, but drive their strategy on volume. Using small order sizes they continuously buy then sell lot sizes of between 100 and 200 shares at fractional price differences.

Liquidity is a by-product of these strategies, which by the law of large numbers, allows them to make profits throughout the day. Using robots, they have removed any emotion out of their strategies, trading as soon as they can rather than waiting to see if a little more can be earned. Statistical control is used to help manage what is bought so that by the end of each day they can close without the risk of holding onto any stock. Artificial intelligence and advanced system development is used to help the mathematical models change into code. Economic trends are not driving decisions, but the analysis of vast data sets and historical patterns to help predict future events. This code is not static but is updated as market conditions change and opportunities are lost.

The traditional activity by fund managers looking to trade at timed intervals is used by HFTs in pattern recognition. HFTs scan billions of records searching for patterns or footprints, which offer statistical opportunity, a process that some have called front-running. Such comments are based on the fact that as HFTs provide liquidity and have no interest in holding any stock, their activity must therefore be questionable. Such comments are driven by fear over robotic behaviour and have little to do with how today’s markets operate. How can you front run a large-order when lot size is hundreds and order details are hidden (MiFID encourage the iceberg order type)? How can you buy up all of the other stock (taking liquidity and paying fees) and then get to the top of the order book on the other side, ahead of all of the other firms who are competing against you? It is far more complex than when broker-dealers were found guilty of such activities.

The financial market is now imposing record fines for nefarious activities. In January this year, the Financial Conduct Authority (FCA) fined Deutsche Bank £163m for money laundering. In January 2016 the US Securities and Exchange Commission (SEC) and New York Attorneys General’s office (NYAG) collectively fined Barclays Capital Inc. and Credit Suisse Securities (USA) LLC more than $150m for dark pool violations. There is clearly market abuse and fraud as individuals such as Navinder Sarao recently admitted to using computers to send false orders to the Chicago Mercantile Exchange (contributing the 2010 flash crash).

Our need for transparency and accountability will be improved when MiFID II takes effect in January 2018, as more trading occurs on a structured, orderly marketplace. Yet record fines only serve to weaken an investor’s confidence that the market is the best place for them to invest their money. This lack of or reduced faith is compounded by stories of how the market is rigged and is no longer fair for the average investor.  Questions about the activities of HFTs have been raised ever since Reg. NMS and MiFID were legislated. Does the investor suffer? Is liquidity phantom? How does regulation control a robotic system? The efficient market hypothesis is clearly at odds with the ability of a HFT to walk in a known direction.

Research on HFTs is difficult because of the highly secretive nature of their operations as they compete with other HFTs for micro-price differences on market inefficiency. They are proprietary and have no need to attract external investors (in the way an investment company presents its portfolios).  There is a clear conflict in the business models used by HFTs and LFTs. No longer able to provide liquidity on all markets at decimal prices, the LFT has seen its profits squeezed as the spread has tightened. The HFT, not having the same overhead structure as the LFT, is able to profit because of the high-frequency strategies used. Some argue that HFTs are parasitic because their actions do not add new information, instead they simply extract profit by unnecessary trading, whilst other argue that a reduced spread means that the long-term investor has a better deal when they buy or sell. Having no formal contract to supply liquidity has caused some to comment that HFTs only trade when they are able to profit and stop when informed trades are sent. Others have said that in the past, when markets turned, the brokers chose to have a long coffee break and not pick up the phone. Other research has shown high activity by HFTs when volatility spikes.

How we can ensure that are market are fair and transparent? All regulation should facilitate price discovery and the long-term investors must be able to execute in a liquid and efficient market. For those who present arguments that spreads have tightened, volatility has reduced and efficiency increased, there are others who can point to contradictory research. People cite phantom liquidity, shares which are available and then disappear when you try to trade, as clear evidence that HFTs are gaming the market. Yet other research 1 that has looked at cancellations on the S&P500 argued that the most common event following a cancellation is for another quote to replace it.  There is no clear evidence on how the market actually works and more detailed research is needed if we are able to present any conclusive argument. What is clear is that the market contains three players: the investor, LFT and HFT. The conflict is between the LFT and the HFT, both looking to earn profits from their trading activities which are driven with the sole intention of creating liquidity for the long-term investor. High-speed trading is not without problems. However slowing the market down because it is unfair that some companies are just too quick is a backward step. The speed at which an investor is able to identify a stock, trade and settle is a reflection of the increased market efficiency. Those activities, which are illegal, need to be punished. Those activities, which strengthen the market, need to be monitored but encouraged. If HFTs cause problems for LFTs because they cannot compete, the question is whether the LFTs are now becoming redundant.

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FTSE 100 ends higher on improving economic activity; gains for the third week

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FTSE 100 ends higher on improving economic activity; gains for the third week 1

By Shivani Kumaresan, Amal S and Shashank Nayar

(Reuters) – London’s FTSE 100 ended higher on Friday after the economy showed signs of improvement this month and was set to gain for the third consecutive week as investors bet that vaccine rollouts would spur economic growth.

British firms fared less badly during February’s lockdown than feared and are upbeat about the prospects for growth later in 2021 when they hope the roll-out of vaccines will allow a major relaxation of COVID-19 restrictions, a survey showed.

The blue-chip FTSE 100 index ended 0.1% higher with miners and banking stocks gaining the most, while the mid-cap index gained 0.5%.

“There is optimism and hope that the vaccine rollouts will eventually help the economy improve while the market is awaiting the government’s lcokdown easing plans to be revealed next week,” said Keith Temperton, an equity sales trader at Forte Securities.

However, data on Friday showed British retail sales tumbled much more than expected in January as non-essential shops went back into coronavirus lockdowns.

The FTSE 100 has recovered nearly 35% from its March 2020 lows and is nearly 13% away from its highest level last year as record stimulus measures and massive vaccine rollouts helped improve investor confidence.

NatWest gained 5.2% and was the third biggest gainer on the FTSE 100 index after it said it would wind down its Irish arm Ulster Bank, as Chief Executive Alison Rose continues to slash away at underperforming parts of the state-owned lender after it swung to a loss in 2020.

Segro Plc rose 1.5% after the real estate investment trust reported a near 11% jump in annual profit for 2020.

Banking group TBC Bank fell 6.1% after a slump in annual underlying profit due to lower interest rates and limited lending growth in the fourth quarter from the COVID-19 pandemic.

 

(Reporting by Shivani Kumaresan and Amal S in Bengaluru; Editing by Vinay Dwivedi, Krishna Chandra Eluri and Jonathan Oatis)

 

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UK bond yields head for biggest weekly rise since June

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UK bond yields head for biggest weekly rise since June 2

LONDON (Reuters) – British government bond prices fell again on Friday as a global debt sell-off continued on expectations of hefty U.S. fiscal stimulus, putting gilt yields on course for their biggest weekly rise since June.

The spread between yields on British 10-year debt and its German equivalent widened to 100 basis points for the first time since March, partly reflecting the faster roll-out of COVID vaccines in Britain which has lifted some of the country’s economic gloom.

Ten-year gilt yields peaked at 0.693% at 1429 GMT, their highest since March 20 during the so-called “dash for cash” at the onset of the pandemic.

Based their latest level they are on course of just under 17 basis points the biggest since the week to June 5.

Sterling also rose above $1.40 for the first time in nearly three years on Friday although it was flat against the euro.

Gilt yields surged at the start of the COVID pandemic due to a scramble for U.S. dollar assets, until the Bank of England calmed markets by restarting its bond purchase programme.

If yields stay where they are, February will see the biggest increase in 10-year gilt yields since October 2016, when markets judged Britain’s referendum vote to leave the EU was having less of an immediate impact on the economy than first thought.

(Reporting by David Milliken; Editing by William Schomberg)

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Dollar extends decline as risk appetite favors equities

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Dollar extends decline as risk appetite favors equities 3

By Stephen Culp

NEW YORK (Reuters) – The dollar lost ground on Friday, extending Thursday’s decline as improved risk appetite attracted buyers to equities and away from the safe-haven greenback.

The U.S. dollar has been weighed down by a string of soft labor market data, even as President Joe Biden’s proposed $1.9 trillion spending package takes shape.

“What the foreign exchange market is looking at in the short term, is the dollar is going to be weak despite progress in the economy because this country has a huge deficit problem,” said Peter Cardillo, chief market economist at Spartan Capital Securities in New York. “The dollar index could easily test the lows of last September.”

Also weighing on the dollar, the real yield gap between the United States and Germany is at its tightest since March, analysts said, despite the recent rise in U.S. Treasury yields.

Bitcoin continues to hover at record highs, and the world’s largest cryptocurrency was last up 2.6% at $52,931.46, nearing $1 trillion in market capitalization.

Its smaller rival, ethereum, was last down 1.0% at $1,920.13.

The digital currencies have gained about 82% and 1,400%, respectively, year to date, leading some analysts to warn of a speculative bubble.

“There may be a place for (cryptocurrencies) somewhere down the road, but the theories that cryptos will replace paper currency are far-fetched,” Cardillo added. “It’s total speculation at this point and people are going to pay the price.”

The Australian dollar, which is closely linked to commodity prices and the outlook for global growth, was last up 1.15% at $0.7858, touching its highest since March 2018.

The New Zealand dollar also gained, closing in on a more than two-year high, and the Canadian dollar advanced as well.

Sterling rose to an almost three-year high amid Britain’s aggressive vaccination programme. It had last gained 0.34% to $1.40.

The euro showed little reaction to a slowdown in factory activity indicated by purchasing manager index data, rising 0.29% to $1.2126.

The yen, gained ground against the dollar and was last at 105.495, creeping above its 200-day moving average for the first time in three days.

(Reporting by Stephen Culp, additonal reporting by Tommy Wilkes; editing by Emelia Sithole-Matarise)

 

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