In the 1986 musical, Little Shop of Horrors, the owner of a flower shop threatens its closure due to low traffic, and employees Audrey and Seymour convince him to keep and display a “strange and interesting plant” (Audrey II) to beef up traffic. But Audrey II gets insatiably hungrier as it grows larger, and it demands to be constantly fed.
High Frequency Market Makers dominate our markets today. They not only dominate the trading volume and order/message flow traffic, they dominate the SRO rulemaking as you well know. If you ever stop and wonder why for-profit exchanges, be they NYSE, NSDQ, BATS or DirectEdge, introduce new order-types of the “add liquidity only” variety, it is because their largest customers and partners, high frequency market makers, have insisted on getting those order types.
This morning we wanted to highlight a study we came across titled The Role of High Frequency Traders in Electronic Limit Order Books. The paper studies identified high frequency market makers in the KOSPI 200 futures. Similarly to their behavior in our own equity markets (which are a much more fragmented marketplace than the KOSPI futures), they cancel/revise 94% of their LIMIT orders, and they trade by crossing the spread using MARKETABLE orders 74% of the time. They also exhibit a large “tag-along” effect, and they make active use of “fleeting orders”.
The authors of the study find that high frequency market makers make use of private information to determine short term future price movements. And they find that in this centralized futures market, high frequency traders are highly impatient! They cross the spread to trade a substantial portion of the time. The study reminds of another futures market, our eMini market on May 6th, 2010. The facts from that day also demonstrate aggressive and impatient high frequency market maker trading! We must remind all the pro-HFT advocates of this when they continue to knowingly misrepresent the facts of the Flash Crash, and blame a mutual fund.
After examining the KOSPI data, the paper concludes that the high frequency market makers make use of fleeting orders actively, and that this has degraded the level of information in limit order books. They write:
The evidence suggests, albeit indirectly, that massive use of limit orders including revision and cancellation by high frequency traders may potentially have negative effects on the market.
And they note that:
The negative relationship between the number of fleeting orders by only a few high frequency traders and the informativeness of the limit order book may emphasize the necessity of putting in place an appropriate order monitoring system that can trace any dishonest intention by a large number of computerized orders to effectively surveil the market.
We now have a public market consisting of a fleeting dance of orders among over a dozen venues, which are dominated by orders by market makers hell bent on collecting rebates. The informational value of the lit markets from that sort of order flow, not to mention the “exhaust” order flow from internalizers, really calls into the question how well our public markets transmit information about asset pricing –price discovery, one of the market’s most important functions.
This needs to change. We think it behooves all of you to monitor the SRO rule-making proposals by the exchanges on a frequent basis. Audrey II is always hungry, and Seymour is constantly eager and willing to feed her. Unfortunately the markets need help from the SEC to keep Audrey II’s appetite in check, and that help is rarely forthcoming. It seems the last, and really only, defense from Audrey II is you, and your comments to the SEC.