High-frequency trading: a survey of market impact

Abstract

honors thesisDavid Eccles School of BusinessFinanceHank BessembinderThe May 6th "flash crash," the result of an overly large sell order in "e-mini" futures on the S&P 500 index, caused American share and future indices to drop approximately 10% in a matter of minutes, only to recover most of the loss by the end of the trading day. At the time, market volatility was already high due to the looming crisis in Greece and such a large trade, being executed without regard to price or time, was left for high-frequency trading firms to pass back and forth. This created volume, but, with little net buying, liquidity was suddenly absent and market depth fell. As a result, the financial industry quickly found high-frequency trading becoming the topic choice with many blaming the crash on the practice. In hindsight, we now know that the "flash crash" was not the result of high frequency trading, but the debates as to the benefit(s) of the practice, and what regulators should allow from it, are still present. The purposes of this research project are to analyze, in context of high-frequency trading, the issue of true liquidity presented to the financial market, to examine potential market manipulation techniques, and to review currently proposed regulation. This thesis begins by providing background information on high-frequency trading, followed by a discussion of the liquidity thought to be provided. I then examine the ability that high-frequency firms have to manipulate the market, through a variety of strategies. Next, I review some of the currently proposed regulatory measures thought to either ensure liquidity or prevent manipulation. I then speculate about the true nature of high-frequency trading as I present my conclusions and recommendations on future regulatory policy responses in this regard