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HFT: Directive Changes and Market Structure

All over the world, certain laws and rules have been executed, intending to de-motivate activities that can be harmful for financial markets. A debate has been going on the question whether the changes may turn out to be detrimental for the market in itself or not. It has been argued that certain regulations made for HFT activities may not bring benefits for the market. Experts say that at one place are the high-frequency traders who act like market makers and have information that is order-flow driven, and at another place there are traders who have no sensitivity towards the latency and randomly come out like Poisson processes. Practical results indicate that these rules and regulations for HFT are not necessarily improving market quality because they do not offer satisfactory evidence relevant to the sudden failures in the market like the 2010 Flash Crash.

Financial Transaction Tax

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Some states from the members of the European Union and the EU itself are already planning to collect or are collecting a FTT. Tax revenues will increase by forcing and ordering financial sector so that it makes a considerable and fair contribution in paying for a burden that is associated to government interventions of repairing banking systems. FTT can be used also to confine excessive trading that is related to HFT and will lead to increase in revenue on the side of the government. At some proper time, FTT can pare back again HFT without destroying other trading types; including trading that is rapid and high-speed. To restrict the short-termism linked with HFT, UK’s Business, Innovation and Skills Committee suggest Britain’s government to study the suitability of the Financial Transactions Tax on equities, on a point which is, in the United Kingdom, the average benefit and profit made from a High Frequency Trade.

Even so, charging taxes upon transactions is nothing new; the UK is charging FTT as stamp duty from the year 1964, with amounts and charges 0.5 percent to the stock’s buyer. This led to the government raising around 5 billion euros when in 1999-2000. In opposition to the FTT, people argue that the scheme of taxing is not sufficient in acting against abstract trading activities. As there is no convincing evidence of FTT’s reduction of short-term volatility, Financial Transaction Taxes may not reduce the bubbles risk in the future.

An epic failure of the execution of FTT was the application of FTT in Sweden during 1984-91 with an intention to collect extra tax revenue as well as rule financial markets. There was a 50-basis-point tax upon equity transactions charged by Sweden which resulted into a transfer of over 50% of volume of equity trading, to London from Sweden. This was a proof of it being a weak revenue source and an insufficient mechanism of regulating equity market.

Letting suspicion be in its place, the European Union declared a FTT, continent-wide, with 0.1% and 0.01% rates for shares and derivatives respectively. Eleven member state of the EU support the legislation; hence expectations say they will raise an extra 30-35 billion euros every year.

In the United States of America, 0.25% tax of stocks’ value and 0.02% of swaps’ and futures’ value will be changed with expecting to increase tax revenue by $150 billion.

Rules for Huge Order Submissions and Cancellations

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Submission as well as cancellation of huge order quantities in very short time periods is the characteristics, most prominent, in HFT.

By delivering large order numbers, one of HFT’s purposes is to provide liquidity along with maintaining profitability, reducing orders will result into a liquidity decline.

Starting from 2012, the major stock exchange of Italy,BorsaItaliana, charges a fee for traders who have OTR more than 100:1 (0.01 euro per order), 500:1 (0.02), or 1000:1 (0.025).

In France, there was an OTR fee implementation in August, 2012. However, smart order routing, market making and the automated implementation of huge orders were out of subjection. This OTR tax had no significant impacts on the quality of the market.

The HFT Act of Germany, declared in the year 2013, resulted into a decline of the order numbers, with the executed trades’ number showing little change. Liquidity providing HFT firms faced a reduction in their orders. It did not affect the quality of the market significantly, with the effect as a whole being negligible.

Discount Structures

According to experts, High-frequency traders gain a good profit amount from rebates. While traders of limit order get compensation with rebates, fees is charged from traders of market order, hence providing liquidity in the market, with traders sending limit orders to build markets, thus providing liquidity to the exchange. The scheme of pricing provides hardly any risk to traders of limit order. UK’s London Stock Exchange as well as the US’s BATS BZX, including many others, is following this structure.

The exchange in Germany, Deutsche Boerse, offered a fee rebate for algorithmic trades with an intention to make them beneficial to liquidity and volume of trading. The financial program favoured technological investments to motivate trade automation. Wider spreads means a higher supply of liquidity, while narrow spreads means less liquidity provision.

Trade Activity Monitoring

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The EU has kept the MIFID 2 under proposal. It has a requirement that algorithmic tradersshould report to the relevant authorities, about their strategies, limits or parameters of trading. Major compliances as well as risk controls. It is hoped to be functional at its best by the year 2017 and mandates and orders HFT traders for storing all the placed orders, with the ones cancelled. This will help authorities to make a plan for risk reduction when sudden changes arise in the market or when malfunctioning algorithms cause disruptions.

In the Rule 613 of the United States SEC, under Regulation National Market System, it asks all the exchanges to make a strategy to build, execute and sustain a stable audit trail which must collect as well as perfectly recognize every order, modification, cancellation and trade implementation for all the equity options and exchange-listed equities.

Minimum Resting Times for Orders

To enforce all the orders to keep a market stay for certain time periods, minimum order resting times are used. A formal minimum resting time of order might stop the growth of wavering orders, while assuring market participants for the available trade terms. But this will result into traders’ discouragement of submitting limit orders as they cannot take back their orders at any time before the minimum resting time. Hence minimum order resting times may result into declined market liquidity.

Circuit Breakers

To be safe from market volatilities, there is an implementation of circuit breakers. NYSE, for e.g. has implemented circuit breakers, in order to prevent market crashes like the one of October, 1987, for the exchange. Circuit breakers pause market-wide trading if stock prices come down, under a threshold.

Based on a rule that governs circuit breakers’ usage, the market pauses for a time of fifteen minutes, when the S&P 500 and DJIA fall below specific thresholds. The LULD plan sets up price bands and individual securities are not allowed to be traded outside it. This plan, signed by US SEC, addresses sudden movements in price experienced by the market on 6 May, 2010.

Structural Delays in Order Processing

In order to act against HFT strategies which develop an environment of a race of technology arms and winner-takes-all, a delay in order processing by specific microseconds was proposed execution. In this way traders are encouraged to increase their speed of trading and reduce the pointless arms race.

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Conclusion

Drastic changes have occurred in the stock market landscape. Transactions are handled by computers with high-powers and sophisticated softwares. Professional traders control computers which make preset parameters for deciding upon buying and selling. Market regulators world-wide are trying to hold on the widening environment of trading that is automated, by taking regulatory initiatives.

In the HFT era, numbers of deviating behaviours in the stock market have been seen. However, experimented evidences indicate that HFT usually enhances the market quality.

Learn more about market microstructure and how HFT impacts market quality?

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