Department of Economics and Finance Chair of Theory of Finance FLASH MARKETS AND A MARKET MAKING ALGORITHM FOR THE ROTMAN INTERACTIVE TRADER CLIENT Supervisor Prof. Nicola Borri Candidate Angelini Berardo Maria Student Reg. No. 671791 Co-Supervisor Prof. Federico Calogero Nucera ACCADEMIC YEAR 2016/2017 FLASH MARKETS AND A MARKET MAKING ALGORITHM FOR THE ROTMAN INTERACTIVE TRADER CLIENT 2 TABLE OF CONTENTS Table of contents ................................................................................................................. 3 Introduction ........................................................................................................................ 7 Chapter 1 ................................................................................................................... 11 HIgh frequency trading and the flash crash of May 6, 2010 ................................................. 11 1.1 Definition of High Frequency Trading ............................................................................... 12 1.2 Functional operation characteristics ................................................................................ 15 1.3 Identification methods ..................................................................................................... 18 1.4 The flash crash of May 6, 2010 ......................................................................................... 21 1.5 High frequency extent ...................................................................................................... 28 1.5.1 Order to Trade Ratio .................................................................................................. 32 1.6 Deployment in Europe ....................................................................................................... 33 1.7 The rise in the United States ............................................................................................ 35 Chapter 2 ................................................................................................................... 41 Effects and High frequency trading regulation .................................................................... 41 2.1 Systemic risk ..................................................................................................................... 42 2.2 Market quality .................................................................................................................. 45 2.2.1 Market efficiency ....................................................................................................... 46 2.2.2 Volatility ..................................................................................................................... 49 2.2.3 Liquidity ..................................................................................................................... 50 2.3 Market integrity ................................................................................................................ 53 2.4 Positive and negative aspects ........................................................................................... 55 2.5 Regulation ......................................................................................................................... 55 2.5.1 IOSCO’s recommendation .......................................................................................... 56 2.5.2 American experience ................................................................................................. 59 2.5.3 European experience ................................................................................................. 63 3 Chapter 3 ................................................................................................................... 67 Main strategies.................................................................................................................. 67 3.1 Latency arbitrage .............................................................................................................. 69 3.2 Liquidity provision ............................................................................................................ 70 3.3 Passive rebate arbitrage ................................................................................................... 71 3.4 Trading on news ............................................................................................................... 73 3.5 Liquidity Detection............................................................................................................ 73 3.6 Ignition momentum .......................................................................................................... 74 3.7 Flash trading ..................................................................................................................... 76 3.8 “Ghost” strategies ............................................................................................................ 77 Chapter 4 ................................................................................................................... 79 Liquidity provision & market making .................................................................................. 79 4.1 Market illiquidity, asset pricing and Bid Ask Spread ......................................................... 79 4.2 Fundamental literature ..................................................................................................... 81 4.3 A theoretical market making strategy .............................................................................. 86 4.3.1 Signal generator ........................................................................................................ 88 4.3.2 Trading strategy ......................................................................................................... 95 Chapter 5 ................................................................................................................... 98 A market making algorithm for the RIT client ..................................................................... 98 5.1 Rotman Interactive Trader Market Simulator Application ............................................... 98 5.2 Structure and main features ........................................................................................... 100 5.3 A market making algorithm for the RIT client ................................................................ 104 Bibliography ............................................................................................................. 118 4 TABLE OF CONTENTS Figure 1 – High Frequency Trading & Algorithmic Trading ................................................. 12 Figure 2 – Global Equity & Equity linked ............................................................................. 20 Figure 3 - Global Equity, Equity linked & Rights Snapshot .................................................. 20 Figure 4 – Dow Jones intraday - 6 May, 2010. .................................................................... 21 Figure 5 – E-Mini Market Depth All Quotes ........................................................................ 25 Figure 6 – E-mini Volume and Price..................................................................................... 25 Figure 7 – E-Mini Buyer Initiated Volume ........................................................................... 26 Figure 8 – Trader Type May 3-6 ........................................................................................... 26 Figure 9 – Asset Class traded by HFTr (USA 2009) .............................................................. 31 Figure 10 – Quote message Growth .................................................................................... 36 Figure 11 – Trade message growth ..................................................................................... 37 Figure 12 – Trade & Quotes per Day 2006 to 2012 ............................................................. 39 Figure 14 – High Frequency Traders main strategies .......................................................... 68 Figure 15 – High Frequency Trading & Liquidity Provision ................................................. 71 Figure 16 – Spread Capturing & Rebate Capturing ............................................................. 72 Figure 17 – Momentum Trading .......................................................................................... 75 Figure 18 - Market Making strategy .................................................................................... 86 Figure 19 - Market Making strategy .................................................................................... 87 Figure 20 - RIT Workspace screenshot .............................................................................. 105 Figure 21 - Excel model screenshot ................................................................................... 106 Figure 22 - Name correspondence .................................................................................... 107 5 To Oriana and Andrea. 6 INTRODUCTION The presence of High Frequency Trading systems has been unveiled by the sudden, rapid and unmotivated Dow Jones flash crash that occurred on May 6, 20101. High Frequency Trading is a mode of intervention on financial markets that uses sophisticated software and hardware tools to implement high frequency trading managed by math algorithms. The crisis caused an immediate investigation by the Securities and Exchange Commission (SEC)2