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Automated and High Frequency Trading

Fredrik HjorthTieto, Stockholm

October 20, 2011

Fredrik Hjorth. Copyright © 2011Tradeflow AB. All rights reserved.

Present Day Situation 1/2• Post MiFID, 2007 November

• Many new execution venues for the same instrument• Executed number of trades per order is increasing

• Fragmentation is now the norm• Exchanges, MTF’s, OTF’s, SI’s and Crossing Systems• Prices can differ from venue to venue• Value of position depends on source for end of day prices

• Cost Pressure• Lower commission fees• ”Do more with less”• Automation


Present Day Situation 2/2• A shift towards automation

• Manual intervention - Exception handling only

• New technology to find liquidity• Smart Order Routing• Consolidated order books• Robotic Trading, Algorithmic trading and Smart Order Routing

• Arbitrage opportunities across market places• Relies on slow reactions from others• Fast reactions removes arbitrage opportunities

• Speed in this sense is relative and not absolute


Automation Is Not New…


Nor Is Evolution!!


Today’s “New School” is tomorrow’s “Old School”

Open Outcry vs. Electronic Order EntryOpen Outcry vs. Electronic Order Entry

Electronic Order Entry vs. Electronic TradingElectronic Order Entry vs. Electronic Trading

Electronic Trading vs. Automated TradingElectronic Trading vs. Automated Trading

Automated Trading vs. ..?? Automated Trading vs. ..??


Sales Trading

• Senior sales with a good performance record

• Handles large order assignments on behalf of clients (agency)• Parent and child orders

• Similar to a proprietary trader

• The trader can be measured based on the performance of how well the order has been executed.

• High levels of commissions

• Still a good business, same people – new tools


Algorithmic Trading• Still agency business and not time sensitive

• Interday - Orders can be open over night

• Distillate of a successful trader’s method• Method becomes a set of rules = algorithm

• Sales people interacts with the client base to offer the algorithms at a lower price

• These are then executed as programs or strategies on a server connected directly to the execution venue.


High Frequency Trading• Proprietary trading and clients trading in their own book

• Intraday – No positions over night.• Many small orders

• Typical behavior - Reverse price strategy• Sells when price dips• Buys when price moves up

• No delays! More money spent = more speed available• Servers are located close the execution venues• Sponsored access

• Arbitrage opportunities diminishing• Entry of more HFT based operations


Ongoing Issues• Same rules apply to HFT as to any other trading operation

• But clients using HFT are not required to be authorized

• Market abuse?• Front running• Pinging

• Tools are not illegal, but breaking the law is• Price manipulation

• Things can still go wrong – only much faster• Flash crash• Outliers – A flickering blur


Impact On Agency Business 1/2• Different feelings about HFT

• Destroys the market• Creates a healthy market

• What we do know• 50% of turnover is through automated trading• Inconclusive that automated trading is the cause to the

current market problems.• Improved price discovery, liquidity and volatility

• Regulatory today• Authorization of proprietary trading • End-customers are not regulated directly

• Controlled by their brokerage or bank


Impact on Agency Business 2/2• Best Execution Policy must be updated

• Is the customer affected? Do we supply HFT tools?• How do we define automated trading?

• No tools = Focus on long term investments• Day traders are growing their use of HFT• Hedge funds use automated trading tools

• Will retail clients move their investments else where?


Impact On Back Office• Number of executed trades increasing rapidly

• How many contract notes for one order with 1 000 trades?• How do we follow up best execution?• Trade reporting

• New execution venues• Each market and broker will require new routines and staff• Automation…• CCP interoperability

• All studies focus on execution costs – What about:• Settlement • Clearing• Custody

• MiFID II – More requirements


MiFID 2 – Definitions 1/2• Automated Trading = Algorithmic Trading

”The use of computer programmes to enter trading orders where the computer algorithm decides on aspects of execution of the order such as the timing, quantity and price of the order.”

• Used by fund managers and brokers• Wide spread use


MiFID 2 – Definitions 2/2• High Frequency Trading is a type of Automated Trading

“Typically not a strategy in itself but the use of very sophisticated technology to implement traditional trading strategies.”

• Used by proprietary traders and day traders• Exclusive service, expensive

• Automated Trading is not always High Frequency Trading


MiFID 2 - Organizational Requirements

• Quantity > Minimum threshold• Authorized as investment firms• Full regulatory oversight

PersonsPersons

• Robust risk control• Mitigate potential trading system errors

• Disclose algorithms (!)• Controls & Filters – Errors and market abuse

FirmsFirms

• Robust risk control• Circuit breakers• Ensure resilience – avoid system break down• Provide equal and fair access

ExecutionVenue

ExecutionVenue


MiFID 2 – Further Regulations• Minimum tick sizes for market operators

• HFT can be forced to become a market maker• Avoid the short term focus• Significant amount of trades in a financial instrument• Same conditions and requirements as for a market maker

• Order book suggestions• Minimum time before order may be cancelled• Maximum order to executed trade ratio per participant

• Algorithms to be approved by competent authority• Problem with know-how• Disclose business secrets


The Danger Lies In the Slow Adaptation• The rules and regulations apply to all financial institutions

• However, when the evolution is moving quickly forward…• …then they who monitor the activities tends to be too slow

to follow.• The business side involves compliance and the risk

management on a ”need to know basis”

• To monitor the markets today in real time requires completely new tools.

• New regulation will not be in place for a few years


Remember - Evolution Is On-Going

Faster!!

Limit reached!

Flexibility!!

Tools available!Faster!

Limit reached!

Flexibility!

Tools available!

RulesRules

ExecuteExecute

DataData(MiFID 2007/11)


In Conclusion• The evolution towards a more automated market for securities

trading will accelerate

• Tools for this type of trading will become cheaper and available

• New rules and new types of products will continuously emerge

• The impact on back office will depend on:• New regulations• Type of business

• The focus of regulation is to create a level playing field.


Further Reading

• ESMA, http://www.esma.europa.eu/

• Finansinspektionen, http://finansinspektionen.se/

• Fondhandlarföreningen, http://www.fondhandlarna.se/

• FSA, www.fsa.gov.uk

• FIX /FAST, www.fixprotocol.org

• Fidessa Fragmentation Index, fragmentation.fidessa.com


QuestionsFredrik HjorthTradeflow AB

[email protected]: +46 8 502 16 370Mobile: +46 734 22 33 70www.tradeflow.se

Member of the FIX Protocol Leauge

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