Why high-frequency trading is a good thing

Edward Backes, Head of Market Supervision, Eurex Frankfurt AG

The recent market turbulence and unusually high volatility that came with it have again

directed wider attention to a particular group of trading participants: high-frequency traders –

that is, participants who place buy and sell orders in the order book with extreme frequency

and, in the vast majority of cases, do not have any open positions left on their books at the end

of the day. The popular perception is that price volatility would be significantly reduced if such

high-speed trading did not exist. The question is: Does the media paint an accurate picture and

is there any truth in headlines like “Profiteering from Stock-Market Turbulence”, “Automated

Panic”, and “High-Frequency Trading – Potential Devastator”)?

Several research institutions have recently examined high-frequency trading and published

extensive studies on the topic. Two examples are a study published in Britain by the

Government Office for Science in September 2011 called “The Future of Computer Trading

in Financial Markets,” and a study by the Goethe University in Frankfurt from April 2011

titled “High-Frequency Trading”. Both studies concluded that high-frequency trading is

being wrongly demonised. In fact, the central message of both studies is clear: Such trading

techniques actually increase liquidity and improve market quality.

As the operator of both cash and derivatives markets, we examined how accurate these

studies’ findings are – particularly in light of Eurex’s guiding principles of transparency, fair

price determination and orderly trading for all market participants. These principles apply for

all market participants, regardless of the trading technology and type of access used.

We used the market activity on 25 August 2011 as the basis of our own research. On this day,

the performance of the DAX Future (FDAX), which tracks the underlying DAX® index of

leading German blue-chip stocks, made the headlines. What had happened on that day? In the

span of 17 minutes, the FDAX fell by more than four percent and then rose again in the

following four minutes by two percent. The rumours circulating in the market afterwards

drew attention to the potential role of high frequency traders in the contract’s dramatic moves.

2

Our analysis generated some interesting results. First, the fall in the FDAX was triggered by

high volume orders of around 6,000 contracts by institutional clients (“buy side”), which were

entered into the trading system as sell positions in small batches with a view to “safeguarding

interests”. As shown in Figure 1, a price drop was not triggered by an illiquid market

situation. In fact, the high volume orders were processed with small price increments.

Average turnover increased in this period to more than 1,700 contracts per minute, far higher

than the monthly average of just under 300 contracts per minute. At the peak, as many as

4,700 contracts per minute were being traded – a clear sign of a highly liquid order book.

Figure 1: Trading in FDAX futures contracts on 25 August 2011 (one-minute intervals)

Second, the turnover seen in this 20-minute period was generated by the activities of a wide

range of participants. A total of around 200 different participants acted as buyers in this

period (in a falling market), including but not limited to high-frequency traders. Around 170

different participants acted on the sell side. The detailed analysis indicates there were up to

122 different participants acting as buyers and 106 different participants acting as

sellers per minute (see Figure 2).

5100

5200

5300

5400

5500

5600

5700

0

2000

4000

6000

8000

10000

12000

14000

15:45 15:50 15:55 16:00 16:02 16:05

No.

of t

rade

d co

ntra

cts

DAX

inde

x po

ints

3

Figure 2: Number of individual buyers and sellers per minute

Third, the high market liquidity was in large part provided by the actions of the high-

frequency traders, as these participants initially absorbed the major sell positions and then

passed them on to protect the market. We have been observing this typical trading pattern for

quite some time. Moreover, the often assumed acceleration of downward movements through

computer-based trading strategies was not observed.

This ad-hoc analysis makes it clear: During times of market turbulence, regulated markets like

Eurex have consistently made valuable contributions to the fair and orderly readjusting of

investment strategies for short, medium and long-term investors thanks to their transparent

and reliable market infrastructure. We offer our participants sufficiently large liquidity pools,

even in volatile market phases. High-frequency traders also make a valuable contribution

here. They help in processing high volume orders in a way that protects the market by placing

a rapid succession of small, non-directional buy and sell orders, thus preventing abrupt price

movements. It can be demonstrated that participants who employ high-frequency techniques

67 6970

108

77

9986

95

97

88

95

81101 103

97110

104

122

10487

61 5555

87

74

7373

74

83

79

80

6782 83

8384

83

106

8886

4,710

-4,710

67

-4000

-3000

-2000

-1000

0

1000

2000

3000

4000

15:45 15:50 15:55 16:00 16:02

Con

tract

s

Number of active market participants

4

serve as liquidity providers, alongside arbitrage investors and hedgers, i.e. participants

carrying out hedging transactions. Our analysis has shown that high volume sell orders in a

difficult market environment found a sufficient number of buyers, allowing them to be

processed in just a few minutes.

Nevertheless, it is essential from the point of view of a market operator to keep track of

changes in the market and technical innovations, and to react if necessary. With a view to the

increasing market share of automated trading strategies, Eurex built protective mechanisms

into the market structure some time ago. These deal with errors, whether they arise from a

mistaken entry (“fat finger”), a panic attack by an inexperienced trader, or an erroneous

algorithm. These mechanisms include, among other things, volatility interruptions, real-time

risk management and order limits. For example, volatility interruptions allow us to

automatically stop trading in individual products in response to unusually large jumps in price

triggered by mistaken entries, stop-order cascades or illiquid market situations. This gives

participants the opportunity to readjust their market assessment and order management before

trading restarts. A chain reaction, such as that seen in the U.S. flash crash, would have been

and is impossible at Eurex.

In summary: It is unfair and counterproductive solely to blame high-frequency traders for

volatile markets and major price fluctuations. At the same time, high-frequency trading

should only take place in an appropriate regulatory environment in which benefits and risks

are well balanced and sufficient consideration is given to both parameters. Minimum

requirements governing organisation and risk control are particularly important here. We

should refrain from over-regulating, however. This is damaging and encourages participants

to evade the rules and migrate to less stringently supervised trading venues, thus depriving

regulated stock and derivatives exchanges of important liquidity.