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Why high-frequency trading is a good thing


Edward Backes, Head of Market Supervision, Eurex Frankfurt AG


The recent market turbulence and unusually high volatility that came with it have again
directed wider attention to a particular group of trading participants: high-frequency traders –
that is, participants who place buy and sell orders in the order book with extreme frequency
and, in the vast majority of cases, do not have any open positions left on their books at the end
of the day. The popular perception is that price volatility would be significantly reduced if such
high-speed trading did not exist. The question is: Does the media paint an accurate picture and
is there any truth in headlines like “Profiteering from Stock-Market Turbulence”, “Automated
Panic”, and “High-Frequency Trading – Potential Devastator”)?


Several research institutions have recently examined high-frequency trading and published
extensive studies on the topic. Two examples are a study published in Britain by the
Government Office for Science in September 2011 called “The Future of Computer Trading
in Financial Markets,” and a study by the Goethe University in Frankfurt from April 2011
titled “High-Frequency Trading”. Both studies concluded that high-frequency trading is
being wrongly demonised. In fact, the central message of both studies is clear: Such trading
techniques actually increase liquidity and improve market quality.


As the operator of both cash and derivatives markets, we examined how accurate these
studies’ findings are – particularly in light of Eurex’s guiding principles of transparency, fair
price determination and orderly trading for all market participants. These principles apply for
all market participants, regardless of the trading technology and type of access used.


We used the market activity on 25 August 2011 as the basis of our own research. On this day,
the performance of the DAX Future (FDAX), which tracks the underlying DAX® index of
leading German blue-chip stocks, made the headlines. What had happened on that day? In the
span of 17 minutes, the FDAX fell by more than four percent and then rose again in the
following four minutes by two percent. The rumours circulating in the market afterwards
drew attention to the potential role of high frequency traders in the contract’s dramatic moves.
Our analysis generated some interesting results. First, the fall in the FDAX was triggered by
                          high volume orders of around 6,000 contracts by institutional clients (“buy side”), which were
                          entered into the trading system as sell positions in small batches with a view to “safeguarding
                          interests”. As shown in Figure 1, a price drop was not triggered by an illiquid market
                          situation. In fact, the high volume orders were processed with small price increments.
                          Average turnover increased in this period to more than 1,700 contracts per minute, far higher
                          than the monthly average of just under 300 contracts per minute. At the peak, as many as
                          4,700 contracts per minute were being traded – a clear sign of a highly liquid order book.


                          Figure 1: Trading in FDAX futures contracts on 25 August 2011 (one-minute intervals)


                           14000
                                                                                                                           5700
                           12000

                                                                                                                           5600
No. of traded contracts




                           10000




                                                                                                                                  DAX index points
                                                                                                                           5500
                            8000

                                                                                                                           5400
                            6000

                                                                                                                           5300
                            4000


                            2000                                                                                           5200


                                0                                                                                          5100
                                    15:45             15:50               15:55              16:00   16:02         16:05



                          Second, the turnover seen in this 20-minute period was generated by the activities of a wide
                          range of participants. A total of around 200 different participants acted as buyers in this
                          period (in a falling market), including but not limited to high-frequency traders. Around 170
                          different participants acted on the sell side. The detailed analysis indicates there were up to
                          122 different participants acting as buyers and 106 different participants acting as
                          sellers per minute (see Figure 2).




                                                                                                                            2
Figure 2: Number of individual buyers and sellers per minute
 4000
                                                                                                                   4,710
                 67      Number of active market participants
 3000
                                                                                                                    122


 2000                                                          97
                                  108                                     95                                  104               87
                                              99          95                                      97                      104
                                                                                      101
                                                     86             88                      103         110
 1000                                                                            81
                                        77
                 67
Contracts




                        69
                             70
            0
                             55
                 61     55
                                        74
-1000                                                73             79           67         83          84
                                              73                                      82          83                       88
                                                          74
                                  87                                      80                                  83                86

-2000                                                          83


                                                                                                                    106
-3000

                                                                                                                -4,710
-4000
                15:45                        15:50                       15:55                         16:00 16:02




Third, the high market liquidity was in large part provided by the actions of the high-
frequency traders, as these participants initially absorbed the major sell positions and then
passed them on to protect the market. We have been observing this typical trading pattern for
quite some time. Moreover, the often assumed acceleration of downward movements through
computer-based trading strategies was not observed.


This ad-hoc analysis makes it clear: During times of market turbulence, regulated markets like
Eurex have consistently made valuable contributions to the fair and orderly readjusting of
investment strategies for short, medium and long-term investors thanks to their transparent
and reliable market infrastructure. We offer our participants sufficiently large liquidity pools,
even in volatile market phases. High-frequency traders also make a valuable contribution
here. They help in processing high volume orders in a way that protects the market by placing
a rapid succession of small, non-directional buy and sell orders, thus preventing abrupt price
movements. It can be demonstrated that participants who employ high-frequency techniques


                                                                                                                                     3
serve as liquidity providers, alongside arbitrage investors and hedgers, i.e. participants
carrying out hedging transactions. Our analysis has shown that high volume sell orders in a
difficult market environment found a sufficient number of buyers, allowing them to be
processed in just a few minutes.


Nevertheless, it is essential from the point of view of a market operator to keep track of
changes in the market and technical innovations, and to react if necessary. With a view to the
increasing market share of automated trading strategies, Eurex built protective mechanisms
into the market structure some time ago. These deal with errors, whether they arise from a
mistaken entry (“fat finger”), a panic attack by an inexperienced trader, or an erroneous
algorithm. These mechanisms include, among other things, volatility interruptions, real-time
risk management and order limits. For example, volatility interruptions allow us to
automatically stop trading in individual products in response to unusually large jumps in price
triggered by mistaken entries, stop-order cascades or illiquid market situations. This gives
participants the opportunity to readjust their market assessment and order management before
trading restarts. A chain reaction, such as that seen in the U.S. flash crash, would have been
and is impossible at Eurex.


In summary: It is unfair and counterproductive solely to blame high-frequency traders for
volatile markets and major price fluctuations. At the same time, high-frequency trading
should only take place in an appropriate regulatory environment in which benefits and risks
are well balanced and sufficient consideration is given to both parameters. Minimum
requirements governing organisation and risk control are particularly important here. We
should refrain from over-regulating, however. This is damaging and encourages participants
to evade the rules and migrate to less stringently supervised trading venues, thus depriving
regulated stock and derivatives exchanges of important liquidity.




                                                                                                 4

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Why High-Frequency Trading is a Good Thing

  • 1. Why high-frequency trading is a good thing Edward Backes, Head of Market Supervision, Eurex Frankfurt AG The recent market turbulence and unusually high volatility that came with it have again directed wider attention to a particular group of trading participants: high-frequency traders – that is, participants who place buy and sell orders in the order book with extreme frequency and, in the vast majority of cases, do not have any open positions left on their books at the end of the day. The popular perception is that price volatility would be significantly reduced if such high-speed trading did not exist. The question is: Does the media paint an accurate picture and is there any truth in headlines like “Profiteering from Stock-Market Turbulence”, “Automated Panic”, and “High-Frequency Trading – Potential Devastator”)? Several research institutions have recently examined high-frequency trading and published extensive studies on the topic. Two examples are a study published in Britain by the Government Office for Science in September 2011 called “The Future of Computer Trading in Financial Markets,” and a study by the Goethe University in Frankfurt from April 2011 titled “High-Frequency Trading”. Both studies concluded that high-frequency trading is being wrongly demonised. In fact, the central message of both studies is clear: Such trading techniques actually increase liquidity and improve market quality. As the operator of both cash and derivatives markets, we examined how accurate these studies’ findings are – particularly in light of Eurex’s guiding principles of transparency, fair price determination and orderly trading for all market participants. These principles apply for all market participants, regardless of the trading technology and type of access used. We used the market activity on 25 August 2011 as the basis of our own research. On this day, the performance of the DAX Future (FDAX), which tracks the underlying DAX® index of leading German blue-chip stocks, made the headlines. What had happened on that day? In the span of 17 minutes, the FDAX fell by more than four percent and then rose again in the following four minutes by two percent. The rumours circulating in the market afterwards drew attention to the potential role of high frequency traders in the contract’s dramatic moves.
  • 2. Our analysis generated some interesting results. First, the fall in the FDAX was triggered by high volume orders of around 6,000 contracts by institutional clients (“buy side”), which were entered into the trading system as sell positions in small batches with a view to “safeguarding interests”. As shown in Figure 1, a price drop was not triggered by an illiquid market situation. In fact, the high volume orders were processed with small price increments. Average turnover increased in this period to more than 1,700 contracts per minute, far higher than the monthly average of just under 300 contracts per minute. At the peak, as many as 4,700 contracts per minute were being traded – a clear sign of a highly liquid order book. Figure 1: Trading in FDAX futures contracts on 25 August 2011 (one-minute intervals) 14000 5700 12000 5600 No. of traded contracts 10000 DAX index points 5500 8000 5400 6000 5300 4000 2000 5200 0 5100 15:45 15:50 15:55 16:00 16:02 16:05 Second, the turnover seen in this 20-minute period was generated by the activities of a wide range of participants. A total of around 200 different participants acted as buyers in this period (in a falling market), including but not limited to high-frequency traders. Around 170 different participants acted on the sell side. The detailed analysis indicates there were up to 122 different participants acting as buyers and 106 different participants acting as sellers per minute (see Figure 2). 2
  • 3. Figure 2: Number of individual buyers and sellers per minute 4000 4,710 67 Number of active market participants 3000 122 2000 97 108 95 104 87 99 95 97 104 101 86 88 103 110 1000 81 77 67 Contracts 69 70 0 55 61 55 74 -1000 73 79 67 83 84 73 82 83 88 74 87 80 83 86 -2000 83 106 -3000 -4,710 -4000 15:45 15:50 15:55 16:00 16:02 Third, the high market liquidity was in large part provided by the actions of the high- frequency traders, as these participants initially absorbed the major sell positions and then passed them on to protect the market. We have been observing this typical trading pattern for quite some time. Moreover, the often assumed acceleration of downward movements through computer-based trading strategies was not observed. This ad-hoc analysis makes it clear: During times of market turbulence, regulated markets like Eurex have consistently made valuable contributions to the fair and orderly readjusting of investment strategies for short, medium and long-term investors thanks to their transparent and reliable market infrastructure. We offer our participants sufficiently large liquidity pools, even in volatile market phases. High-frequency traders also make a valuable contribution here. They help in processing high volume orders in a way that protects the market by placing a rapid succession of small, non-directional buy and sell orders, thus preventing abrupt price movements. It can be demonstrated that participants who employ high-frequency techniques 3
  • 4. serve as liquidity providers, alongside arbitrage investors and hedgers, i.e. participants carrying out hedging transactions. Our analysis has shown that high volume sell orders in a difficult market environment found a sufficient number of buyers, allowing them to be processed in just a few minutes. Nevertheless, it is essential from the point of view of a market operator to keep track of changes in the market and technical innovations, and to react if necessary. With a view to the increasing market share of automated trading strategies, Eurex built protective mechanisms into the market structure some time ago. These deal with errors, whether they arise from a mistaken entry (“fat finger”), a panic attack by an inexperienced trader, or an erroneous algorithm. These mechanisms include, among other things, volatility interruptions, real-time risk management and order limits. For example, volatility interruptions allow us to automatically stop trading in individual products in response to unusually large jumps in price triggered by mistaken entries, stop-order cascades or illiquid market situations. This gives participants the opportunity to readjust their market assessment and order management before trading restarts. A chain reaction, such as that seen in the U.S. flash crash, would have been and is impossible at Eurex. In summary: It is unfair and counterproductive solely to blame high-frequency traders for volatile markets and major price fluctuations. At the same time, high-frequency trading should only take place in an appropriate regulatory environment in which benefits and risks are well balanced and sufficient consideration is given to both parameters. Minimum requirements governing organisation and risk control are particularly important here. We should refrain from over-regulating, however. This is damaging and encourages participants to evade the rules and migrate to less stringently supervised trading venues, thus depriving regulated stock and derivatives exchanges of important liquidity. 4