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The Impacts of High-Frequency Trading on the Financial THE IMPACTS OF HIGH-FREQUENCY TRADING ON THE FINANCIAL MARKETS’ STABILITY By Haval Rawf Hamza Supervisor Dr. Jayaram Muthuswamy Thesis Submitted in Partial Fulfillment of the Requirements for the Degree of Master of Business Administration Kent State University March 2015 I Thesis written by Haval Rawf Hamza B.S., Technical College of Sulaimani, Sulaimani, Iraq MBA, Kent State University, Kent, Ohio, USA Approved by ___________________________________, Chair, Master Thesis Committee ___________________________________, Members, Master Thesis Committee ___________________________________ ___________________________________ ___________________________________ Accepted by ___________________________________, Chair, Department of Business Administration ___________________________________, Dean, College of Business II ABSTRACT High-frequency trading (HFT) is a new area in financial markets. The term HFT refers to a subset of algorithmic trading (AT). After Michael Lewis' book "Flash Boys" HFT has quickly become a term known to the general public. As the debate over HFT continues, many concerns about contributions of HFT to market quality are raised by market participants, media, regulators, academics, and general public. Although many studies have been conducted to understand high-frequency traders’ (HFTs) behaviors and their market impacts, each study targeted a different market, therefore the conclusions cannot be generalized to markets which are organized differently. Nonetheless, by studying papers that examine different markets’ samples, we can advance our understanding of HFTs’ behaviors in a wider area, and we can generalize our conclusion on a higher level. This paper focuses on micro-structural effects of HFT on the financial markets. Throughout this paper, changes in liquidity, price discovery, transaction cost, volatility, and market fragmentation were discussed. A review of the literature showed that: first, HFTs play a constructive role in financial markets. They reduce the bid–ask spread, cut execution cost and facilitate price efficiency. HFTs’ ability to avoid adverse selection and inventory management makes them successful in providing liquidity. Second, HFT and markets’ volatility are positively correlated. However, it is not clear that this correlation is due to HFTs’ algorithmic strategies nor speed of trading. Many researchers claim that speed of trading does not have any negative effects on the financial market. Hence, regulators are urged to focus more on the algorithmic strategies employed by HFTs in their regulations instead of speed of execution. III TABLE Of CONTENTS ABSTRACT ........................................................................................................................................ III DEDICATION ....................................................................................................................................VI ACKNOWLEDGMENTS................................................................................................................ VII CHAPTER 1 ......................................................................................................................................... 1 Introduction ........................................................................................................................................... 1 1.1. High-frequency Trading Definition...................................................................................... 3 1.1.1. SEC Detention................................................................................................................ 4 1.1.2. Netherlands Authority for the Financial Markets (AFM) Definition ......................... 4 1.2. High-frequency Trading Transaction Volume..................................................................... 5 1.3. High-frequency Trading Profit ............................................................................................. 7 1.4. Problem Statement ................................................................................................................ 9 1.5. Research Questions ............................................................................................................... 9 CHAPTER 2 ....................................................................................................................................... 11 Literature Review ............................................................................................................................... 11 2.1. Theoretical Paper ................................................................................................................. 11 2.2. NASDAQ Datasets .............................................................................................................. 14 2.3. Chi-X and Euronext Dataset ............................................................................................... 16 2.4. Financial Services Authority (FSA) Dataset ..................................................................... 16 2.5. E-mini Dataset ..................................................................................................................... 17 2.6. NASDAQ-OMX Stockholm Exchange Dataset ................................................................ 17 2.7. Computerized Trade Reconstruction (CTR) Dataset Provided by the CME ................... 18 2.8. CRSP and the Thomson Reuters Institutional Holdings Databases ................................. 19 CHAPTER 3 ....................................................................................................................................... 20 Discussion of Papers........................................................................................................................... 20 IV 3.1. Low Frequency Traders “Human Traders” versus Automated Traders........................... 20 3.2. High-frequency Trading Working Mechanism ................................................................. 22 3.3. High-frequency Traders’ Strategies ................................................................................... 24 3.3.1 High-frequency Traders’ Legal Strategies ................................................................. 24 3.3.2. High-frequency Traders’ Manipulation Strategies: ................................................... 27 3.4. The Impacts of High-frequency Traders on the Financial Markets’ Stability ................. 31 3.4.1. High-frequency Traders’ Co-Location ....................................................................... 31 3.4.2. High-frequency Trading and Price Discovery: .......................................................... 33 3.4.3. High-frequency Trading and Market Liquidity ......................................................... 34 3.4.4. Bid-ask Spread ............................................................................................................. 36 3.4.5. Execution Costs ........................................................................................................... 37 3.4.6. Speed of Execution ...................................................................................................... 39 3.4.7. High-frequency Traders’ Effects on Firms’ Decision Making ................................. 39 3.5. The Impacts on the Market Volatility ................................................................................ 40 3.5.1 Flash Crash May 6th, 2010........................................................................................... 43 3.6. High-frequency Trading in the Foreign Exchange Market ............................................... 45 3.7. High-frequency Trading and Market Risks ....................................................................... 48 3.7.1. The Systematic Risk of High-frequency Traders....................................................... 48 3.7.2. The Fairness of High-frequency Trading ................................................................... 50 3.8. Regulatory Issues................................................................................................................. 51 CHAPTER 4 ....................................................................................................................................... 56 Concluding Statement ........................................................................................................................ 56 REFERENCES ................................................................................................................................... 59 V DEDICATION I dedicate this thesis… To my loving family, especially to my parents for all their sacrifices to provide a better life and education for me. To my sisters and brothers for their patience and understanding To all members of the Higher Committee for Education Development in Iraq for supporting me from the beginning of program until the end. To my undergraduate professors Dr. Othman Abdul Qader Hama Amin and Dr. Kawa Mohammed Faraje Qaradaghi who motivated me to reach my dreams. To all my friends VI ACKNOWLEDGMENTS Writing this thesis was challenging since it was the first thesis offered by the Masters in Business Administration (MBA) department at Kent State University. In the meantime, it was great experience. Writing this thesis was only possible with help of so many people during my life at Kent State University. I wish to thank all of them for their support. I would like to express my deep gratitude for my superior, Dr. Jayaram Muthuswamy,
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