UNIVERSITA’ DEGLI STUDI DI PADOVA DIPARTIMENTO DI SCIENZE ECONOMICHE ED AZIENDALI “M.FANNO” CORSO DI LAUREA MAGISTRALE IN ECONOMICS AND FINANCE TESI DI LAUREA “The High Frequency Trading Phenomenon and its Influence on Capital Markets: Evidences from the Pound Flash Crash” RELATORE: CH.MA PROF.SSA BALDAN CINZIA LAUREANDO: CAVESTRO STEFANO MATRICOLA N. 1103591 ANNO ACCADEMICO 2016 – 2017 2 Il candidato dichiara che il presente lavoro è originale e non è già stato sottoposto, in tutto o in parte, per il conseguimento di un titolo accademico in altre Università italiane o straniere. Il candidato dichiara altresì che tutti i materiali utilizzati durante la preparazione dell’elaborato sono stati indicati nel testo e nella sezione “Riferimenti bibliografici” e che le eventuali citazioni testuali sono individuabili attraverso l’esplicito richiamo alla pubblicazione originale. Firma dello studente _________________ 3 4 TABLE OF CONTENTS INTRODUCTION ..................................................................................................................... 9 1. THE BIRTH OF HIGH FREQUENCY TRADING ......................................................... 11 1.1. Revolution of Financial Markets ................................................................................... 11 1.2. Evolution of Electronic Trading .................................................................................... 11 1.3. Regulatory Developments in the Capital Markets ........................................................ 13 1.4. Electronic Trading Drivers ............................................................................................ 17 1.4.1. Smart Order Routing (SOR) ...................................................................................... 17 1.4.2. Direct Market Access (DMA) and Sponsored Access (SA) ..................................... 18 2. HIGH FREQUENCY TRADING DEFINITIONS AND FEATURES ............................ 21 2.1. The need of defining High Frequency Trading ............................................................. 21 2.2. Definitions of Algorithmic Trading .............................................................................. 22 2.3. Characteristics of Algorithmic Trading ........................................................................ 23 2.4. Definitions of High Frequency Trading ........................................................................ 26 2.5. Characteristics of High Frequency Trading .................................................................. 27 2.5.1. Low-Latency Requirements ...................................................................................... 29 2.6. How to Identify High Frequency Traders? ................................................................... 32 3. HIGH FREQUENCY TRADING STRATEGIES ............................................................ 35 3.1. Introduction to HFT Strategies ...................................................................................... 35 3.2. Algorithmic Trading Strategies ..................................................................................... 36 3.2.1. First Generation Execution Algorithms .................................................................... 37 3.2.2. Second Generation Execution Algorithms ................................................................ 38 3.2.3. Third Generation Execution Algorithms ................................................................... 38 3.2.4. Fourth Generation Execution Algorithms ................................................................. 39 3.3. High Frequency Trading Strategies .............................................................................. 39 3.3.1. Liquidity Providing Strategy ..................................................................................... 40 3.3.1.1. Spread Capturing .................................................................................................. 41 3.3.1.2. Rebate Driven ....................................................................................................... 41 3.3.2. Statistical Arbitrage Strategy ..................................................................................... 42 3.3.2.1. Market Neutral Arbitrage ..................................................................................... 43 3.3.2.2. Cross Asset, Market & ETF Arbitrage ................................................................. 43 3.3.3. Directional Strategy ................................................................................................... 44 3.3.3.1. Momentum Trading .............................................................................................. 44 3.3.3.2. Liquidity Detection Strategy ................................................................................. 45 5 3.3.3.2.1. Quote Matching ................................................................................................ 46 3.3.3.2.2. Momentum Ignition .......................................................................................... 47 3.3.4. Structural Strategy ..................................................................................................... 48 3.3.4.1. Latency Arbitrage .................................................................................................. 49 3.3.4.2. Flash Trading ........................................................................................................ 51 3.4. Considerations on High Frequency Trading Strategies ................................................. 52 4. HIGH FREQUENCY TRADING AND MARKET QUALITY ....................................... 53 4.1. Introduction to Literature Review ................................................................................. 53 4.2. Market Quality ............................................................................................................... 54 4.2.1. Liquidity ..................................................................................................................... 55 4.2.2. Price Discovery .......................................................................................................... 57 4.2.3. Volatility .................................................................................................................... 58 4.3. Theoretical models on market quality ........................................................................... 59 4.4. Empirical studies on market quality .............................................................................. 61 4.4.1. HFT direct approach .................................................................................................. 61 4.4.2. HFT indirect approach ............................................................................................... 65 4.5. Summary of Academic Literature Review .................................................................... 67 5. RISKS OF HIGH FREQUENCY TRADING ................................................................... 69 5.1. Introduction to Risks of High Frequency Trading ......................................................... 69 5.2. Two-Tiered Markets ...................................................................................................... 69 5.3. Phantom Liquidity ......................................................................................................... 70 5.4. Market Manipulation ..................................................................................................... 72 5.5. Operational Risk ............................................................................................................ 74 5.6. Systemic Risk ................................................................................................................ 75 5.7. Flash Crashes ................................................................................................................. 76 5.7.1. The Flash Crash of May 6, 2010 ................................................................................ 77 5.7.2. Mini-Flash Crashes .................................................................................................... 82 6. HIGH FREQUENCY TRADING REGULATION .......................................................... 87 6.1. Regulatory Activity and Discussion .............................................................................. 87 6.2. HFT Regulation in the US ............................................................................................. 87 6.3. HFT Regulation in the European MiFID II ................................................................... 91 6.4. Ideas and Proposal Measures ......................................................................................... 95 6.5. Considerations on HFT Regulation Developments ....................................................... 98 7. EMPIRICAL ANALYSIS OF THE POUND FLASH CRASH ....................................... 99 7.1. Introduction of the Pound Flash Crash .......................................................................... 99 6 7.2. The GBP Foreign Exchange Market ........................................................................... 100 7.3. A Flash Event in Three Stages .................................................................................... 102 7.4. Descriptive Analysis of the Pound Flash Crash .......................................................... 106 7.5. Analysis of Liquidity during the Pound Flash Crash .................................................