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High Frequency Trading in Financial Markets

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High Frequency Trading in Financial Markets High Frequency Trading in Financial Markets Zur Erlangung des akademischen Grades eines Doktors der Wirtschaftswissenschaften (Dr. rer. pol.) von der Fakultät für Wirtschaftswissenschaften am Karlsruher Institut für Technologie (KIT) genehmigte DISSERTATION von Shuo Sarah Zhang, M. Sc. Ind. Eng. Tag der mündlichen Prüfung: 11.12.2013 Referent: Prof. Dr. Christof Weinhardt Korreferent: Prof. Dr. Marliese Uhrig-Homburg 2013 Karlsruhe Acknowledgements I would like to express my deep gratitude to Prof. Dr. Christof Weinhardt for giving me the opportunity to pursue my research interests at the Institute of Information Systems and Marketing (IISM) and for his support and advice throughout my dissertation. I would further like to thank Prof. Dr. Ryan Riordan for his guidance and without whom this work would not have been possible. I would also like to thank Prof. Dr. Marliese Uhrig-Homburg for insightful discussions and helpful comments. My thanks also go to Prof. Dr. Martin Ruckes and Prof. Dr. Kay Mitusch for serving on my thesis committee. I am also very grateful to Prof. Albert S. Kyle, Prof. Andreas Park, and Prof. Peter Cziraki for comments on my work and for their support - it made all the difference. My sincere thanks go to my colleagues at the IISM. I could not have wished for better collegues. In particular I would like to thank my colleagues Dr. Marc Adam, Stephan Meyer, Dr. Andreas Storkenmaier, Dr. Florian Teschner, and Dr. Martin Wagener for their feedback and guidance. It has been a privilege to be a member of this inspiring and enthusiastic team. I gratefully acknowledge financial support by the IME Graduate School at the Karl- sruhe Institute of Technology (KIT) funded by Deutsche Forschungsgemeinschaft (DFG) and financial support by the Karlsruhe House of Young Scientists (KHYS) for the research stay at University of Toronto. Finally, but most importantly, I thank my family and friends. I thank my parents Lanju and Wucheng for their unconditional love and support throughout my life, and Dominik for his love, forbearance, and encouragement. I owe them more than I can ever put in words. Contents List of Figuresv List of Tables vii List of Abbreviations ix 1 Motivation and Introduction1 1.1 Modern Financial Markets..........................2 1.1.1 Technological Innovation in Financial Markets..........3 1.1.2 The Role of HFT...........................4 1.1.3 Applications of Financial Market Engineering..........6 1.2 Research Questions and Structure......................6 2 HFT and the Electronic Evolution of Financial Markets 11 2.1 The Electronic Evolution of Financial Markets.............. 12 2.1.1 Measures of Market Quality..................... 12 2.1.2 Market Quality Framework..................... 17 2.1.3 Case Study: IBIS vs. Xetra...................... 23 2.2 Economic and Regulatory Aspects of HFT................. 30 2.2.1 HFT Definition and Strategies.................... 32 2.2.2 HFT Literature............................ 36 2.2.3 HFT Regulation............................ 38 2.2.4 Case Study: HFT and Liquidity................... 41 2.3 Summary.................................... 46 3 HFT and Information Processing 49 3.1 Related Literature............................... 51 3.1.1 HFT and Price Discovery...................... 51 3.1.2 Categories of Information Events.................. 52 3.2 Data and Sample Descriptives........................ 53 3.2.1 Sample Descriptives......................... 54 3.2.2 Hard and Soft Information..................... 56 3.3 Results..................................... 57 3.3.1 Correlation Results.......................... 57 3.3.2 Impact of Information Events on Returns and Net Trading... 61 3.3.3 Influence of Information Events on Price Discovery....... 80 iii iv Contents 3.3.4 Influence of Information Events on Trading Profits....... 83 3.4 Summary.................................... 88 4 HFT and Human Trading Behavior 91 4.1 Related Literature and Hypothesis Development............. 93 4.1.1 Experimental and Neuro Finance.................. 93 4.1.2 Market Microstructure and Mechanism Design.......... 95 4.2 A Market Framework for Human-Computer Interaction........ 96 4.2.1 Individual Behavior and Emotional State............. 98 4.2.2 Application to IS Constructs.................... 99 4.2.3 Market Outcome and Market Design............... 100 4.3 The Experiment................................ 103 4.3.1 Experimental Design......................... 103 4.3.2 Participants and Incentives..................... 104 4.3.3 Treatment Structure and Procedure................ 105 4.3.4 Implementation............................ 108 4.4 Statistical Analysis.............................. 112 4.4.1 Individual Trader Analysis..................... 112 4.4.2 Market Level Analysis........................ 113 4.5 Results..................................... 114 4.5.1 Effects on Emotional Arousal.................... 114 4.5.2 Trading Behavior........................... 118 4.5.3 Market Quality............................ 125 4.6 Summary.................................... 140 5 Conclusion and Outlook 143 5.1 Contributions................................. 143 5.2 Implications.................................. 147 5.3 Future Research................................ 148 5.4 Summary.................................... 151 A Sample Stocks and Robustness Checks (Chapter 3) 153 A.1 List of Sample Stocks............................. 153 A.2 Reverse Ordering of HFT and NHFT net trading in VARX Model... 155 A.3 Trading Profits - Robustness over Time................... 157 B Experimental Design and Instructions (Chapter 4) 163 B.1 Participant Instructions............................ 163 B.2 Emotion Regulation Questionnaire..................... 168 References 169 List of Figures 2.1 Framework for Market Quality....................... 18 3.1 Exemplary News Item............................ 58 3.2 Impact of Hard Information Shocks - 1 Second Analysis........ 65 3.3 Initiated Net Trading after Information Events.............. 68 3.4 Passive Net Trading after Information Events............... 69 3.5 Calculation of Fictitious Profits....................... 84 4.1 Market Framework for Human-Computer Interaction.......... 97 4.2 Trading Graphical User Interface...................... 109 4.3 Pseudo-Code for ZIP agents......................... 111 4.4 Direct and Indirect Effects on Trading Behavior: Model 1a and Model 1b 113 4.5 Direct and Indirect Effects on Market Quality: Model 2......... 114 4.6 Heart Rate for different Treatments..................... 116 4.7 Alpha for different Treatments....................... 127 4.8 Alpha for different Treatments and Market Settings........... 128 4.9 Profit Dispersion for different Treatments................. 131 4.10 Market Quality for different Market Settings............... 134 v List of Tables 2.1 Sample Constituents............................. 25 2.2 Descriptive Statistics............................. 28 2.3 Liquidity and Information Measures over time.............. 31 2.4 Final Sample Constituents and their Market Capitalization....... 42 2.5 Trading and Quoting Activity of HFTs................... 45 2.6 HFT Liquidity Provision and Demand................... 47 3.1 Summary Descriptives............................ 55 3.2 Correlation of Information Shocks, Net Trading and Trading Volume. 59 3.3 Impact of Information Shocks on Stock Returns.............. 64 3.4 Impact of Information Shocks on Net Trading............... 67 3.5 Impact of Information Shocks on Net Trading - Robustness over time. 72 3.6 Impact of Positive and Negative Futures Shocks on Net Trading.... 77 3.7 Impact of Positive and Negative Volatility Shocks on Net Trading... 78 3.8 Impact of Positive and Negative News Shocks on Net Trading..... 79 3.9 Influence of Trading after Information Shocks on Price Discovery... 82 3.10 HFT Profits after Information Shocks.................... 85 4.1 Experiment Summary Statistics....................... 105 4.2 Experimental Design............................. 107 4.3 Direct and Indirect Effects on Price Aggressiveness............ 117 4.4 Moderated Effects on Price Aggressiveness................ 119 4.5 Direct and Indirect Effects on Trade Aggressiveness........... 122 4.6 Moderated Effects on Trade Aggressiveness................ 124 4.7 Direct and Indirect Effects on Market Efficiency.............. 126 4.8 Direct and Indirect Effects on Profit Dispersion.............. 130 4.9 Direct and Indirect Effects on Human Profit Dispersion......... 132 4.10 Direct and Indirect Effects on Spreads................... 135 4.11 Direct and Indirect Effects on Volume................... 137 4.12 Direct and Indirect Effects on Depth.................... 138 A.1 Sample Descriptives............................. 154 A.2 Impact of Information Shocks on Net Trading - Reverse Ordering... 155 A.3 HFT Profits after Information Shocks - Robustness over time...... 157 vii List of Abbreviations AFME Association for Financial Markets in Europe AT Algorithmic Trading ATs Algorithmic Traders ATS Alternative Trading System CBOE Chicago Board Options Exchange CEP Complex Event Processing CFTC U.S. Commodity Futures Trading Commission CME Chicago Mercantile Exchange DAX Deutscher Aktien Index DMA Direct Market Access DWZ Deutsche Wertpapier-Datezentrale EBS Electronic Broking Services ECG Electrocardiography ECN Electronic Communication Networks EEG Electroencephalography EMG Facial Electromyography ER Emotion Regulation ETF Exchange-Traded Fund Eurex European Exchange FCA Financial Conduct Authority fMRI functional
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