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High Frequency Trading and Fairness Master’s Degree in Economics and Finance Final Thesis High Frequency Trading and Fairness Supervisor Ch. Prof.ssa Caterina Cruciani Assistant supervisor Ch. Prof.ssa Gloria Gardenal Graduand Eva Mazzer Matriculation number 857162 Academic Year 2019 / 2020 2 A mio nonno, che mi ha mostrato i veri valori della vita A mia madre, che mi ha insegnato a farmi forza stando sempre al mio fianco anche da lontano A mio padre, che ha lavorato per aiutarmi a costruire un futuro Alla mia famiglia e ai miei amici, che mi hanno sostenuta, sempre e incondizionatamente 3 4 Summary Summary ................................................................................................................................................. 5 Introduction ........................................................................................................................................... 7 Chap 1 Role of HFT on the market......................................................................................... 9 1.1 High Frequancy Trading .................................................................................................. 9 1.1.1 What is HFT? ............................................................................................................... 9 1.1.2 Strategies adapted ................................................................................................... 11 1.1.3 Diversity among HFTs ........................................................................................... 14 1.1.4 Differences with low frequency trading (mimicking technique) .......... 18 1.2 What do we know about HFT? .................................................................................... 20 1.2.1 Selected HFT strategies ......................................................................................... 21 1.2.3 HFT profitability ...................................................................................................... 24 1.3 Pro and cons of HFT for the market .......................................................................... 27 1.4 Consequences on market efficiency .......................................................................... 33 1.4.1 Importance of liquidity .......................................................................................... 33 1.4.2 HFT, is it playing a dysfunctional role on the market? .............................. 35 1.4.3 Market Timing analysis and Market efficiency ............................................ 36 1.5 Conclusions ......................................................................................................................... 39 Chap2 Effects on the real economy .................................................................................... 41 2.1 May 6, 2010, Flash Crash ............................................................................................... 41 2.1.1 A brief background of what the E-mini contract is ..................................... 42 2.1.2 What happened on May 6, 2010 ........................................................................ 43 2.1.3 The impact of the Flash Crash............................................................................. 46 2.2 Manipulative Strategies ................................................................................................. 49 2.3 Regulation adopted.......................................................................................................... 52 2.3.1 European Legislation ............................................................................................. 53 2.3.2 American Legislation .............................................................................................. 60 2.4 Conclusions ......................................................................................................................... 65 Chap3 Fairness and High frequency trading .................................................................. 69 3.1 Ethics in age of automation .......................................................................................... 69 5 3.2 Market abuses .................................................................................................................... 74 3.3 Concept of Deception and Fairness ........................................................................... 75 3.4 Fairness and regulation ................................................................................................. 81 3.5 Conclusions ......................................................................................................................... 84 Chap 4 Empirical research on ethical behavior ............................................................. 85 4.1 Introduction ....................................................................................................................... 85 4.2 Participants ......................................................................................................................... 86 4.3 Results .................................................................................................................................. 88 4.3.1 First hypothesis: importance of regulation ................................................... 88 4.3.2 Second Hypothesis: Perception of financial market fairness ................. 91 4.3.3 The dimensions of Shefrin and Statman ......................................................... 93 4.4 Conclusions ......................................................................................................................... 99 Conclusions ....................................................................................................................................... 101 Bibliography ..................................................................................................................................... 105 Appendix ............................................................................................................................................ 109 Survey ............................................................................................................................................. 109 6 Introduction This paper is going to discuss the role of High Frequency Trading (HTF) in financial market and whether it helps the economy or if it is obstructing other agents in the market. HFT is a subset of the algorithmic trading (‘AT’) distinguished by the speed at which it processes and determines plays in the market. This is due to the sophis- ticated technology components that are reducing the latency, the time occurring be- tween when the order is placed and when it is executed. HFT is not just algorithms that help execute orders, but brains that think on their own, making decisions in milliseconds backed by machine learning based on proprietary strategies pro- grammed by a firm. Characterizing the HFT strategies could give an insight into the motives for trading, which could impact market quality, also providing evidence on intraday return predictability. The regulatory and real effects on the market, taking into consideration the so-called Flash-Crash, particularly the one that occurred on May 6, 2010, will be discussed further in this paper. Ultimately, after the analysis of pros and cons are evaluated, this paper will conclude with the implications sur- rounding HFT and fairness in the market – which is the main focus of this paper. Human beings are supposed to know what it is right and what it is wrong but trying to put a border between the two of them is not definitively clear with regards to HFT. Using this assumption, an empirical study will be conducted to see if the assumption holds true and whether fairness in the market is adversely affected by HFT. 7 8 Chap 1 Role of HFT on the market 1.1 High Frequancy Trading 1.1.1 What is HFT? This research paper wants to focus on the study of algorithms trading, focusing spe- cifically on high frequency trading (henceforth HFT1). As the market has radically changed during the last three decades, starting with the introduction of the com- puter in trading, equity and future markets have been highly automated and High Frequency Trading has become the main responsible for the trading volume. HFT is a subset of the algorithmic trading (‘AT’) distinguished by the speed at which it processes and determines plays in the market. This is due to the sophisticated technology components that are reducing the latency, the time occurring between when the order is placed and when it is executed. In this chapter HFT strategies will be discuss, most of which are already known in the market. Many of them act as market-makers, the major difference is the lower costs and that is why they have replaced human market-makers. The other main strategy is conducting cross-market arbitrage (Jones, 2013). Then the pros and cons HFT is producing in the marketplace will be analyzed. However, let us start from the beginning, focussing on its introduction and development. First, we should imagine how the picture of the stock market has changed. Once it was a large room with monitors that were showing bids and offers to physical peo- ple that were deciding to buy or sell securities. Since computers took the place of those people in the crowded stock exchange rooms, we have a different idea of it; everyone from everywhere can place an order and see it immediately carried out. That is what has happened in the last few decades, where technology transformed 1 referred also as High
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