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High Frequency Trading – Highway to Financial Hell, Or Economic Salvation? High Frequency Trading – highway to financial hell, or economic salvation? -a comprehensive review of the High Frequency Trading literature- Iwona Pobłocka A thesis submitted in fulfillment of the requirements for the Master’s degree: Industrial Engineering and Management (Specialization in Financial Engineering & Management) Examination committee members: Dr. Reinoud Joosten (Supervisor) – University of Twente, Industrial Engineering and Business Information Systems (IEBIS) Dr. Berend Roorda (Co-supervisor) – University of Twente, Industrial Engineering and Business Information Systems (IEBIS) Abbreviations and symbols AHFTI Artificial HFT Intelligence AI Artificial Intelligence ATS Automated Trading System CDA Continuous Double Auction CPU Central Processing Unit (Super) DOT Designated Order Turnaround ECNs Electronic Communication Networks FED Federal Reserve FINRA Financial Industry Regulatory Authority FT Fundamental Trader GPU Graphics Processing Unit HFT High Frequency Trader, High Frequency Trading IEX Investors Exchange IT Information Technology LOB Limit Order Book LT Liquidity Trader MC Market Clearing MM Market Maker MPID Market Participant Identifier ms Milliseconds NASDAQ National Association of Securities Dealers and Automated Quotations NBBO National Best Bid and Offer NYSE New York Stock Exchange Reg. HTS Regulation Alternative Trading System Reg. NMS Regulation National Market System SEC Securities and Exchange Commission SIP Securities Information Processor 2 ∆ Price notch 휖 External information Unit of stocks that a trader wants to buy or sell 푃 Price 푃푀퐶1 Market clearance price calculated at time t by MM 푥 (푃푀퐶푡 − ∆푡 ) Pressurized or notched price. 푥 푄푡 Quantity of stock that trader x is willing to sell or buy at time t 푠 Seconds 푡 Time 푥 휃푡 Demand curve of player x at time t 3 Acknowledgements With the completion of this thesis I would like to express my gratitude to some people. First and foremost, I would like to say thank you to Dr. Reinoud Joosten. Thank you for giving me the opportunity to graduate under your supervision and letting me work on the topic of High Frequency Trading. Thank you also for the insightful discussions and useful feedback which have definitely contributed to making this thesis a comprehensive study. I would also like to thank Dr. Berend Roorda for being by co-supervisor and Abhishta Abhishta for providing me valuable feedback to my thesis. To my friends, Eline, Ruud and Thomas I am thankful for the many pleasant meetings, trips and dinner parties that we have had and hopefully we will still have for a long time to come. You guys are the best. I would like to say thank you to my parents, for always giving me the right example of how to be a good person, motivating and encouraging me in every situation. Also thank you very much for the many packages with Polish treats making sure that I always have a little bit of home with myself. I would like to thank my boyfriend Ivan for being always there when I need it, making me laugh and being my groupie. I have never met a person so similar to me with so many opposite qualities, but I guess that this is the magic recipe that is needed to make things work. 4 Table of Contents Abbreviations and symbols ........................................................................................................................... 2 Acknowledgements ....................................................................................................................................... 4 1. Introduction .......................................................................................................................................... 8 2. The history of the connected stock exchange and algorithmic trading ............................................... 9 2.1 What is an algorithm? ....................................................................................................................... 12 3. Distinction between continuous time and discrete time ................................................................... 14 3.1 Is the HFT trader adhering to a truly continuous time game plan? .................................................. 14 4. Market participants............................................................................................................................. 17 4.1 The High Frequency Trader (HFT) ..................................................................................................... 17 4.2 The intermediaries ............................................................................................................................ 17 4.3 Fundamental traders ........................................................................................................................ 17 4.4 Opportunistic traders ........................................................................................................................ 18 4.5 Market Makers .................................................................................................................................. 18 5. Market structure ................................................................................................................................. 20 5.1 Stock market order types .................................................................................................................. 21 5.1.2 Limit Order ................................................................................................................................. 21 5.1.3 Market Order ............................................................................................................................. 21 5.1.4 Continuous Double Auction Order (also known as Double Auction) ......................................... 21 5.1.5 Immediate-or-cancel Order ....................................................................................................... 22 5.2 Submission of orders on the stock exchange, the Limit Order Book ................................................ 22 6. Potential HFT strategies on the stock exchange ................................................................................. 27 6.1 HFT strategies ................................................................................................................................... 27 6.1.1 Electronic Front Running ............................................................................................................ 27 6.1.2 Large Block Orders ..................................................................................................................... 27 6.1.3 Sliced orders ............................................................................................................................... 27 6.1.4 Pinging ........................................................................................................................................ 28 6.1.6 Manipulating the price ............................................................................................................... 28 6.1.7 Immediate-or-cancel sell ........................................................................................................... 29 6.1.8 Rebate strategies ....................................................................................................................... 29 6.2 Controversial HFT strategies ............................................................................................................. 29 5 6.2.1 Front running by insider trading ................................................................................................ 29 6.2.2 Wash trading .............................................................................................................................. 30 6.2.3 Spoofing and layering ................................................................................................................ 31 6.2.4 Smoking ...................................................................................................................................... 32 6.2.5 Stuffing ....................................................................................................................................... 33 6.2.6 Momentum Ignition ................................................................................................................... 33 6.3 HFT strategies on a single market ..................................................................................................... 33 6.4 Multimarket HFT strategy ................................................................................................................. 35 6.5 Machine learning .............................................................................................................................. 38 7. The playing field enabled by the stock exchange, the various games that can occur ........................ 42 7.1 Prisoners’ dilemma – when the third dog runs away with the bone ................................................ 43 7.2 Zero sum game theory ...................................................................................................................... 45 7.3 Subsequential game, a model for interactions between HFTs, FTs and MMs ................................. 46 7.3.1 Modeling the interactions of the traders .................................................................................. 46 7.3.2 Model description .....................................................................................................................
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