In the last four decades, technological progress led to an electrification of stock trading systems. Traders were enabled to place their orders, which were later processed via electronic networks, with the help of computers. Soon they realized that the profitability of trading strategies could be increased by employing computer algorithms to trade autonomously, reducing time needed to analyze information, publish quotes as well as trigger and process trades. This led to the implementation of Algorithmic Trading (AT). High Frequency Trading (HFT) is a subset of AT, at which financial instruments are traded by algorithms at very high speed.
The past has shown that negative developments on capital markets are intensified by HFT. Andrei Kirilenko explains in his work “The Flash Crash: The Impact of High Frequency Trading on an Electronic Market” that HFT did not trigger the Flash Crash but intensified the volatility that resulted from the event. Also on the 19th of October 1987, “Black Monday”, the increasing computerization of stock trading processes led to a significant price drop. As a consequence, the high and still growing market share of HFT leads to an increase in risk that a simple correction turns into a serious drop in prices causing market instability. Theoretically HFT should increase efficiency in financial markets. However, due to the empirical observation mentioned above, it seems that HFT takes effect the other way round. It seems that, at least under certain circumstances, HFT enlarges volatility. This cannot be explained by the economic neoclassical theory. This problem is discussed in a lot of literature in which several different approaches have been made to explain it.
The aim of this paper is to discuss why HFT cannot be fully explained by the neoclassical theory of economics. Therefore, the controversial positions in literature will be presented and discussed. Primarily, its negative influence on volatility seems to contravene the modern finance. Furthermore, in the course of this work it will be illustrated that, by employing strict regulation of financial markets, this negative impact cannot be reduced to a sufficient extent in order for HFT to be characterized as market optimizing, according to the neoclassical theory of economics.
Inhaltsverzeichnis (Table of Contents)
- 1 Introduction
- 1.1 Problem
- 1.2 Aim
- 1.3 Research Questions
- 1.4 Scientific Method
- 1.5 Structure of the paper
- 2 Fundamentals of HFT
- 2.1 History of HFT and its presence in current markets
- 2.1.1 Algorithmic Trading (AT)
- 2.1.2 Definition and characteristics of HFT
- 2.1.3 HFT's fraction of market activity in the US and Europe
- 2.2 Technology used for HFT
- 2.2.1 Software for HFT
- 2.2.2 Hardware for HFT
- 2.3 Users of HFT
- 2.4 Strategies of HFTs
- 2.4.1 Liquidity Provision (Market Making)
- 2.4.2 Liquidity Detection
- 2.4.3 Arbitrage
- 2.4.3.1 Market Neutral Arbitrage ("Pairs Trading")
- 2.4.3.2 Cross Asset-, Cross Market- & ETF-Arbitrage
- 3 The effect of HFT on capital markets and the Economic Neoclassical Theory
- 3.1 The Economic Neoclassical Theory and its relation to HFT
- 3.2 The effect of HFT on liquidity
- 3.3 The effect of HFT on price discovery
- 3.4 The effect of HFT on volatility
- 4 The regulation and supervision of HFT
- 4.1 Manipulation and the importance of regulation and supervision of HFT
- 4.2 The Flash Crash
- 4.3 General regulatory measures
- 4.3.1 Unfiltered/Naked Sponsored Access
- 4.3.2 Flash Orders
- 4.4 The regulatory response to the Flash Crash
- 4.4.1 Circuit breakers
- 4.4.2 Stub quotes and erroneous trades
- 4.5 Other possible regulatory measures and their effect on volatility
- 4.5.1 Tobin tax
- 4.5.2 Short sale constraints
Zielsetzung und Themenschwerpunkte (Objectives and Key Themes)
The objective of this paper is to analyze the impact of High Frequency Trading (HFT) on capital markets, specifically examining why its effects cannot be fully explained by neoclassical economic theory. The paper will explore the controversial viewpoints surrounding HFT and its influence on market volatility.
- The impact of HFT on market volatility
- The limitations of neoclassical economic theory in explaining HFT's effects
- The role of regulation and supervision in mitigating the negative impacts of HFT
- Different HFT strategies and their market effects
- The technological underpinnings of HFT
Zusammenfassung der Kapitel (Chapter Summaries)
1 Introduction: This chapter introduces the topic of High Frequency Trading (HFT), highlighting its rapid growth within increasingly electronic trading systems. It establishes the problem of HFT's seemingly contradictory effects: while theoretically enhancing market efficiency, empirical evidence suggests that it can exacerbate volatility, as seen in events like the Flash Crash. The chapter outlines the paper's aim to investigate this discrepancy through the lens of neoclassical economic theory and explore the need for regulation.
2 Fundamentals of HFT: This chapter delves into the core aspects of HFT, tracing its historical development from algorithmic trading and defining its key characteristics, including its speed and reliance on advanced technology (both software and hardware). It explores the diverse range of HFT users and the various strategies they employ, such as liquidity provision, liquidity detection, and different types of arbitrage. The chapter lays a crucial foundation for understanding the mechanisms and intricacies of HFT that will be analyzed in subsequent chapters.
3 The effect of HFT on capital markets and the Economic Neoclassical Theory: This chapter examines the impact of HFT on capital markets within the framework of neoclassical economic theory. It explores how the theory attempts to explain HFT's effects on liquidity, price discovery and volatility. The chapter likely contrasts the theoretical predictions with empirical observations, showcasing the limitations of the neoclassical model in fully accounting for the observed market phenomena related to HFT.
4 The regulation and supervision of HFT: This chapter focuses on the regulatory challenges posed by HFT, discussing the potential for market manipulation and the importance of effective supervision. It examines specific events, like the Flash Crash, to illustrate the need for regulatory intervention. The chapter likely discusses existing and proposed regulatory measures, such as circuit breakers, restrictions on certain order types, and broader policy options, analyzing their effectiveness in mitigating HFT's negative consequences and their impact on market volatility.
Schlüsselwörter (Keywords)
High Frequency Trading (HFT), Algorithmic Trading, Market Volatility, Neoclassical Economics, Market Regulation, Liquidity, Price Discovery, Flash Crash, Arbitrage, Regulatory Measures.
Frequently Asked Questions: A Comprehensive Language Preview on High-Frequency Trading
What is the main topic of this paper?
This paper comprehensively analyzes the impact of High-Frequency Trading (HFT) on capital markets. It specifically investigates why HFT's effects are not fully explained by neoclassical economic theory and explores the controversial viewpoints surrounding HFT's influence on market volatility.
What are the key objectives of the research?
The main objective is to analyze HFT's impact on capital markets, focusing on the discrepancies between its theoretical and empirical effects. The research will explore the limitations of neoclassical economic theory in explaining HFT, the role of regulation in mitigating negative impacts, various HFT strategies and their market effects, and the technology behind HFT.
What are the key themes explored in the paper?
The paper explores several key themes: the impact of HFT on market volatility; the limitations of neoclassical economic theory in explaining HFT; the role of regulation and supervision in mitigating negative impacts of HFT; different HFT strategies and their market effects; and the technological underpinnings of HFT.
What are the chapters and their summaries?
Chapter 1 (Introduction): Introduces HFT, highlighting its rapid growth and seemingly contradictory effects (enhancing efficiency while potentially exacerbating volatility). It sets the aim to investigate this discrepancy using neoclassical economic theory and explores the need for regulation.
Chapter 2 (Fundamentals of HFT): Delves into HFT's core aspects, its history from algorithmic trading, key characteristics (speed, technology), user types, and strategies (liquidity provision, detection, arbitrage). It lays the foundation for understanding HFT's mechanisms.
Chapter 3 (HFT's Effect and Neoclassical Theory): Examines HFT's impact on capital markets through the lens of neoclassical economic theory, exploring its effects on liquidity, price discovery, and volatility. It likely contrasts theoretical predictions with empirical observations, highlighting the limitations of the neoclassical model.
Chapter 4 (Regulation and Supervision of HFT): Focuses on the regulatory challenges posed by HFT, including market manipulation and the importance of supervision. It examines events like the Flash Crash, discusses existing and proposed regulatory measures (circuit breakers, order type restrictions), and analyzes their effectiveness in mitigating negative consequences.
What are the keywords associated with this paper?
High-Frequency Trading (HFT), Algorithmic Trading, Market Volatility, Neoclassical Economics, Market Regulation, Liquidity, Price Discovery, Flash Crash, Arbitrage, Regulatory Measures.
What is the structure of the paper?
The paper is structured with an introduction, followed by chapters detailing the fundamentals of HFT, its impact on capital markets within the framework of neoclassical economic theory, and the regulation and supervision of HFT. It concludes with a summary and key findings.
What specific HFT strategies are discussed?
The paper discusses several HFT strategies, including liquidity provision (market making), liquidity detection, and various types of arbitrage (market neutral arbitrage, cross-asset, cross-market, and ETF arbitrage).
What regulatory measures are considered?
The paper explores existing and potential regulatory measures, such as circuit breakers, restrictions on unfiltered/naked sponsored access and flash orders, the Tobin tax, and short sale constraints. The impact of these measures on market volatility is also analyzed.
How does the paper relate to neoclassical economic theory?
The paper critically examines the ability of neoclassical economic theory to explain the observed effects of HFT on capital markets, particularly regarding liquidity, price discovery, and volatility. It highlights discrepancies between theoretical predictions and empirical evidence.
- Citation du texte
- Stefan Höppel (Auteur), 2013, High Frequency Trading. Economic Necessity or Threat to the Economy?, Munich, GRIN Verlag, https://www.grin.com/document/267885
