Modern Microstructure: High Frequency Trading, Spread Capture, and The Flash Crash

Questions to think about in advance How should Market Quality be measured? What is the impact of High Frequency Trading on Market Quality? What caused the Flash Crash? What was the impact of the Flash Crash? What can/needs to be done to prevent another Flash Crash?

Outline 1.Market Making 2.Order Placement 3.High Frequency Trading and Market Quality 4.Analytics 5.Synthesis: The Flash Crash

Market Making Consideration – Spread – Potential rebate Costs – Adverse selection – Information leakage Strategies – Place – Revise – Cancel Did market making activities contribute to the flash crash?

Order Placement Order Placement is at the Heart of Algorithmic Trading Algorithmic Logic Algorithmic Degrees of Freedom – Price – Timing – Size – Destination Sofianos, Xiang, and Yousefi "All-in shortfall and optimal order placement", January 2011 "Going to the races: venue toxicity comparisons", December 2010 "'Good fills, bad fills' and venue toxicity", November 2010 Potential Results

HFT & Market Quality Recent Research: "An analysis of trades by high frequency participants on the London Stock Exchange“ Jarnecic and Snape, 2010 "High frequency trading and its impact on market quality“ Brogaard, 2010 "Low-latency trading“ Hasbrouck and Saar, 2010 "Algorithmic trading and information“ Hendershott and Riordan, 2009 "Does algorithmic trading improve liquidity?“ Hendershott, Jones, and Menkveld, 2010

Analytics Watching market action in real-time P&L versus various benchmarks Interval volumes Destination Attribution

The Flash Crash Setting the stage – Market down ~ 2.5% – Greek unrest – Bid side liquidity shrinking The e-mini trade – Only 9% of volume – Created unusual flurry of HF activity – Contract went limit down Equities and ETFs – Lots on cancelling with no replenishment – Retail stop-loss market orders triggered – Many matched with “stub” orders left on book Who is to blame? – Waddell and Reed – Barclays – Retail investors – Agent for retail customers – HF market makers – Regulation – Market structure – All of the above? Regulatory Response – Single Stock Circuit Breakers – Ban On Naked Access – Consolidated Audit Trail