7
Introduction
A few months ago, having just finished my exams, I was trying to find a suitable topic to conclude my
university career in the best way possible. As I had already mentioned to Professor Claudio Pacati, during a
exchange of opinions in his office, my master's graduation thesis will be the finishing stone on my academic
path, I really wanted to give my most valid and worthy piece, without being trivial or repetitive. Luckily,
just when I was giving up hope of finding a topic soon, Dr. Massimiliano Morelli, drew my attention to what
would become the concept of the following work, that is High Frequency Trading. I hope that Prof. Pacati,
who later expressed this choice as being “trendy”, will forgive me.
The writing of this thesis, sees the financial world going through one of the worst moments of turmoil in its
short history. The sovereign debts crisis which has recently hit many countries in the old continent,
(especially Portugal, Ireland, Italy, Greece and Spain, the so-called “PIIGS”), continues to influence social,
political and economic issues.
The “sub-prime” mortgage crisis, (with the incredible collapse of some financial banks like Lehman
Brothers), has strongly tried the trust of the “housewives” of the financial world, passing on the message
that this is the main reason for the growing percentage of poverty that is tormenting the industrial world,
manipulated by unscrupulous individuals incredibly like “Gordon Gekko”. All this without forgetting that
every day , the major national and international news agencies report on the latest update on the wavering of
the national stocks tax interest in comparison to the benchmark German Bunds and the high instability of the
markets, emphasizing the fears and anxieties of those who fear losing their purchasing power.
My choice to inquire into the dynamics of High Frequency Trading is contained in this context. I could say
that this choice derives from my personal admiration for “trading”, which started in the first triennial of
“Richard Goodwin” University, maybe even earlier, since my father Claudio Marchetti worked for more than
30 years in the “Banca di Monterrigioni Credito Cooperativo – CRAM”. Therefore I have been surrounded
by finance from an early age. This, together with the passion for knowledge that my mother Franca Dondoli
passed on to me lead to my decision.
On an introductory note, High Frequency Trading (HFT) can simply be defined as a trading technique
which, through the use of sophisticated computer systems and algorithms allows us to elaborate buying and
selling orders in a matter of milliseconds, taking advantage of the slightest imperfections in the markets
and/or the difference in price of the same bond quoted on various markets. Obviously HFT cannot be
satisfactorily defined in so few words, and the aim of this work is in fact to present, as precisely as possible,
a concept that has been around for some time now but is still unknown to many.
Since HFT concerns 75% of the exchange volume of the USA markets, and is contagiously spreading to
European markets, one of the aims of this work is to ascertain whether HFT is an advantage or a
disadvantage or both for the stability of the global financial system.
8
In this sense, the starting point can be what is known as “Flash Crash” day that is May 6
th
2010, when a
selling order arriving from a high frequency software provoked losses for over 60% in some ETF bonds
quoted on the USA market, before they in their turn could just as quickly recover and consolidate (more or
less) initial levels. In this sense, therefore, we will endeavour to understand if this new trading technique can
be controlled by man of if there is a real risk of it slipping out of hand or being manipulated, provoking even
more serious disasters than that in May 2010.
In fact, some paragraphs in the second chapter have been dedicated to illustrating the associated regulations.
Therefore to sum up this thesis, without any research or simulation activity, it tries to explain the basic
concepts of the modern trading technique which is slowly (but not too slowly) expanding into the world's
major financial markets. This will be possible thanks to the understanding of the mathematical models
dedicated to the volatility and latency, which have been illustrated in the main part (chapters 3-4-5). The
former are particularly important since they were suggested with the aim of foreseeing and checking possible
market turmoils like those 3 years ago. The latter will help to understand the reason why we are induced to
looking for low values of the same with more and more insistence.
Concluding, and in extreme synthesis, the structure of this work is as follows :
[ ] : The first chapter emphasises the concept of High Frequency Trading, and the two
major concepts connected to it, that is “latency” and “co-location”. Furthermore, this chapter shows
the most common strategies used, both legal and illegal, and the most important advantages and
disadvantages connected to HFT. Particular consideration has been given to the MTA situation, that
is the Italian one;
[ ] : In the second chapter, the events of the first (6
th
May 2010) and the second (23
rd
April,
2013) Flash Crashes are explained in detail. During these events many bonds and ETFs underwent
great losses in a matter of minutes, plunging losses (> 60%), and then returned to pre-crash level. In
particular paragraph [2.5] shows the measures taken to avoid similar crises happening again . All
this supported by the inquiry made by the CTF and the SEC;
[ ] : The third chapter starts to tackle the concept of HFT from a more mathematical point
of view. It introduces two of the most famous measures devised with the aim of preventing (or trying
to) dangerous turmoils in the market: the PIN measure and it's later development of the VPIN
measure (and its variants), were both developed by [Easley et al.];
9
[ ] : The fourth chapter contains a structured criticism of the two mathematical measures
illustrated in [ ], promoted by [Anderson and Bondarenko], in “VPIN and the flash crash“
(2013). The entire chapter shows the results of research carried out by [A&B] and the conclusions
arrived at as regards reliability or unreliability of the systems;
[ ] : The fifth chapter, together with the two preceding ones, is the heart of this work, since
it shows on a theoretical level and with practical examples, the latency models developed by
[Moallemi and Sağlam];
[ ]: Finally, the sixth and last chapter, contains the final observations and a comment on
the conceptual subject of this thesis.
Siena, December 2013
11
Chapter 1
st
- Introduction to High Frequency Trading: History and Development.
At the time of writing, the latest frontier of the financial markets, thanks to the constant development of
informational technologies, seems to be given by '"High Frequency Trading", which is the extreme evolution
of "Algorithmic Trading" (which has undergone enormous expansion since the late 1980s), also known as
"Automatic Trading", "Black-Box Trading" and as "Trading-Robot". In the specific Italian markets the term
"macchinette" has been coined to emphasize the use of automated software, and the Dutch media is used to
using the term "flitshandel."
Over the years, technology has improved the way news is disseminated, the quality of financial analysis, and
the speed of communication among market participants, with a subtle and continuous impact on the markets,
leaving the most persistent mark. Thanks to these changes, markets have become more transparent and have
reduced the number of traditional inefficiencies. Unfortunately an entirely new set of arbitrage opportunities
were also born. Until the 1980s, securities markets were run in an entirely manual fashion.
The first electronic execution system was the DOT ("Designated Order Turnaround"), introduced by the
New York Stock Exchange (NYSE).
[1.01]
In 1983 made its first appearance the "Nasdaq’s computer-assisted execution system" followed by (in 1984)
the “small-order execution system”. Since the second half of eighties, brokers and dealers were able to use
computer-based execution on selected exchanges and networks, while to use the systematic trading, it was
necessary to wait another few years (1990).
In 1992 was born the first electronic platform of Chicago Mercantile Exchange (CME), the so-called
"Globex", that initially traded only CME futures and the most liquid currency pairs, but only one year later it
was able to trade equity futures. Ten years after the first appearance of Globex, in 2002, electronic trading
on the CME reached an average daily volume of 1.2 million contracts!
It was only in 2000 that was launched in financial markets, the first fully electronic U.S. options exchange by
the New York International Securities Exchange (ISE).
As already said, the first appearance of the "trading computer-assisted" was around the end of the 90s, but it
was only ten years later, around 2006-2007, the financial market has experienced a boom in volumes,
resulting from Algorithmic Trading, and from the High Frequency Trading.
Adoption of electronic trading has grown from 25 percent of trading volume in 2001 to 85 percent in 2008.
The reputation HFT is relatively recent as it is come to the attention of the general public between 2007 and
2008, since six years ago there was their first use in regard to the management of some funds, thanks to high
level researchers of a team of analysts and mathematicians.
12
Later, a "pure strategy" of HFT was used with success for the first time by the American fund "Renaissance
Technology". In July 2009, all the world did known the existence HFT thanks to the arrest of Sergy
Aleynikov (former employee of Goldman Sachs, responsible for HF software), who stolen the codes used by
G.S.
In May 2010 occurred the first "Flash Crash"! For a few minutes, the entire financial world holds its breath,
following the evolution of the Dow Jones Industrial Average (DJIA), and right after many questions, were
posed, about the possibility that the increasing development and the increasing popularity HFT, can amplify
the impact of systemic financial shocks, and adversely affect the integrity and quality of the market (price
discovery efficiency, volatility and liquidity). In the wake of these important questions, and wanting to try as
much as possible to prevent and mitigate the negative effects of hypothetical future scenarios, the authorities
have initiated a discussion about policy instruments asking for more disclosure obligation of HFTr and acting
on the elements of microstructure markets (circuit breakers, limit to the tick size regimes commission).
Today, the most important exchanges are realized on “Electronic Communication Networks” (ECNs), also
known as‚"dark liquidity pools", in which orders are quickly transmitted and matched buyers and sellers, and
where trader identities and orders remain anonymous, moreover it is not possible to see the market depth.
1.2 – HFT concept and main features.
The “High Frequency Trading”
[1.02]
finds its strength in the use of automated software, which is able to
analyze the market conditions and automatically execute, within a few microseconds, thousands of orders to
on multiple markets. The software automatically decides the quantity, price and time of insertion, according
to the programming guidelines included in the development phase. Speed is one of the main features HFT
because no human is able to process the information, coming from the market, with the same speed. The
formulas used were designed to allow the software to infiltrate in the books of negotiation, before normal
operators, and generate transactions that generally close within a few tenths of a second.
By doing so, HFF collect sensitive information from the market, at times leading to unjustified increases in
the prices of securities, and in some cases high volatility spikes.
It is logical to think of a kind of "insider trading automatic" with orders that can be deleted and/or moved on
all levels of the book (flash orders) making it (almost) impossible the scalping activity and confuse the
operation of those who do not make use of HF software. At this point it is very useful to present a very
simple example to better understand the enormous potential of HFT.
Let’s suppose that on a generic market which we call "Fantasy Stock Exchange" a buy order of 100,000
shares of "Unknown Stock" at list price of $ 7.30 is incoming. The HF software is able to intercept the order
in the space of 30 milliseconds, anticipating its visibility on the destination book. Buy orders are
immediately issued to buy all the shares available on the market at a price of $ 7.30, resulting in the rise of
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