A recently released European academic study claims that High Frequency Trading (HFT) exacerbates volatility and generates flash crashes, directly contradicting a US academic study released less than six months ago.

High Frequency Trading HFT

The paper, “Rock Around The Clock: An Agent-Based Model of Low and High Frequency Trading,” written by European academics Sandrine Leal of the ICN Business School in France, Mauro Napoletano and Andrea Roventini from Observatoire Français des Conjonctures Economiques and Giorgio Fagiolo from the Laboratory of Economics and Management takes direct aim at HFT trading techniques.

“High-frequency traders use directional strategies to exploit market information produced by low-frequency traders,” the paper writes, pointing out the differences between “traders” and “investors” who are typically low frequency.  The paper’s money shot is clear when it says “we find that the presence of high-frequency trading increases market volatility and plays a fundamental role in the generation of flash crashes.”

Dueling academic papers

This observation flies in the face of an August, 2013 academic paper from Robert E. Whaley and Nicolas P.B. Bollen of Vanderbilt University’s Owen Graduate School of Management. Their paper, “Futures Market Volatility: What Has Changed?” drew the key conclusion that algorithmic and high frequency trading did not appear to have affected price volatility.  The study tracked 15 markets and found that volatility moved through cycles of high and low volatility and that price spikes were most often attributed to macro-economic events.  The study, facilitated by the Futures Industry Association (FIA), an industry trade group, and sponsored by the four leading futures exchanges, said that “we now have empirical evidence that volatility in the futures markets has neither increased nor decreased once the effects of macro-economic shocks are removed.” The 15 futures contracts covered by the study consist of three short-term interest rate contracts, four long-term interest rate contracts, five equity index contracts, two crude oil contracts, and one sugar contract.

The European study takes a very different view, but narrows its focus on flash crashes: “The emergence of flash crashes is explained by two salient characteristics of high-frequency traders, i.e., their ability to i) generate high bid-ask spreads and ii) synchronize on the sell side of the limit order book,” the study noted.  The study then moved to a key point by saying “we find that higher rates of order cancellation by high-frequency traders increase the incidence of flash crashes but reduce their duration.”

HFT order cancellation methods targeted

The study of order cancellation techniques is what hits the pain point in some HFT trading models.  To bolster their study the role of HFT order cancellation on price, researchers performed a Monte-Carlo experiment they varied the number of periods an unexecuted HFT order stays in the book, while keeping all the other parameters at their baseline values. The result was a reduction in the order cancellation rate and a decrease in market volatility and the number of flash-crash episodes.

“We have investigated the recovery phases that follow price-crash events, noting that HF traders’ order cancellations play a key role in shaping asset price volatility and the frequency as well as the duration of ash crashes. Indeed, higher order cancellation rates imply higher market volatility and a higher occurrence of ash crashes,” the European paper concluded.  “Our results suggest that order cancellation strategies of HF traders cast more complex effects than thought so far, and that regulatory policies aimed at curbing such practices should take such effects into account.”

The recent study challenging HFT comes on the back of a March, 2012 study that claimed “fast traders,” or HFT, cost “slow traders,” or investors, $233 million per year.