High‐frequency Trading: Review of the Literature and Regulatory Initiatives around the World

• Published date: 01 February 2016
• Author: Kee H. Chung,Albert J. Lee
• Date: 01 February 2016
• DOI: http://doi.org/10.1111/ajfs.12120

High-frequency Trading: Review of the

Literature and Regulatory Initiatives

around the World*

Kee H. Chung**

School of Management, State University of New York at Buffalo and

School of Business, Sungkyunkwan University

Albert J. Lee

School of Management, State University of New York at Buffalo

Received 15 November 2015; Accepted 16 November 2015

Abstract

This paper provides a review of the literature on high-frequency trading and discusses various

initiatives taken by regulatory authorities around the world to address its potential detrimen-

tal effects on market quality and investor welfare. Empirical evidence to date generally sug-

gests that high-frequency trading has improved market quality during normal times. What is

not clear is the role of high-frequency traders during episodic periods of market crash and

extreme volatility. A fruitful area of future research may be a comparative analysis of the role

of high-frequency traders and the efficacy of various regulatory initiatives across periods of

varying market conditions.

Keywords High-frequency traders; Market quality; Market volatility; Market regulation; Algo-

rithmic trading

JEL Classification: G14, G18, G23

1. Introduction

High-frequency trading (HFT) is one of the most significant developments in the

securities markets around the world in recent years. HFT is a program trading plat-

form that uses powerful computers to transact a large number of orders at very fast

speeds. HFT uses complex algorithms to analyze multiple markets and execute orders

*This work was supported by the Korean Securities Association and the National Research

Foundation of Korea Grant funded by the Korean Government (NRF-2014S1A3A2036037).

**Corresponding author: Kee H. Chung, Louis M. Jacobs Professor, Department of Finance,

School of Management, State University of New York (SUNY) at Buffalo, Buffalo, NY 14260,

USA. Tel: 716-645-3262, Fax: 716-645-3823, email: keechung@buffalo.edu.

Asia-Pacific Journal of Financial Studies (2016) 45, 7–33 doi:10.1111/ajfs.12120

©2016 Korean Securities Association 7

based on market conditions. High-frequency traders include proprietary trading

firms, proprietary trading desks of a multi-service broker-dealer, and hedge funds.

With the widespread use of electronic trading, automatically generated quotes

(autoquotes), and colocation services, traders now can respond to new information

at a rate that has never been previously possible.

1

The United States Securities and

Exchange Commission (U.S. Securities and Exchange Commission (SEC), 2010, p.

41) notes that “the speed of trading has increased to the point that the fastest tra-

ders now measure their latencies in microseconds.” Hasbrouck and Saar (2013)

report that the fastest traders in their study sample react to new market events

within two to three milliseconds. Given that the speed advantage can translate into

profitable trading opportunities, HFT, equipped with state-of-the-art technologies

to submit and cancel orders instantaneously, is rapidly gaining attention and popu-

larity. A survey by the Authority for the Financial Markets (AFM), 2010 indicates

that HFT accounted for about 20% to 40% of trading volumes in different Euro-

pean trading venues, and that the HFT shares are likely to continue to escalate.

Gomber et al. (2011) suggest that estimated market shares of HFT in the United

States range from 40% to 70%.

2

Researchers have found that HFT is profitable. For instance, Menkveld (2013)

shows that high-frequency traders in Dutch stocks earn a gross profit of 9 542 euros

per day after deducting exchange and clearing fees, enjoying an annualized Sharpe

ratio of up to 23.43. Similarly, Brogaard et al. (2014a) find that high-frequency tra-

ders in large cap NASDAQ stocks earn a daily average profit of USD5642. The

profit increases to USD6651 after trading fees and rebates are considered, since

high-frequency traders that supply liquidity receive a sizeable amount of rebates.

3

Given the prevalence of HFT, researchers and market regulators have analyzed

the impact of HFT on market quality. When equity and equity futures prices

rapidly oscillated during the Flash Crash in 2010, a great deal of media blamed

high-frequency traders as a cause of the extreme volatility. However, a thorough

investigation following the crash revealed that, while HFT may have exacerbated

market conditions during the event, it did not trigger the crash. In fact, many aca-

demic studies conclude that HFT generally improves market quality. However, it is

unclear whether HFT improves market quality even when the market is experienc-

ing tumultuously high volatility such as during the Flash Crash.

Regulators and trading venues have found it necessary to devise a plan to mod-

erate the potentially pernicious effects of HFT. For example, financial transaction

1

See Jain (2005) for an international survey of electronic trading, Hendershott et al. (2011)

for a study of NYSE autoquotes and rise of algorithmic trading, and O’Hara (2015) for a dis-

cussion of colocation services and their impact on the speed of transferring information.

2

Market share of HFT during the mid-2000s was <25% (source: http://blogs.wsj.com/market-

beat/2009 /06/19/rise-of-the-market-machines).

3

Also see Kearns et al. (2010), Litzenberger et al. (2012), and Carrion (2013) for discussions

of HFT profits.

K. H. Chung and A. J. Lee

8©2016 Korean Securities Association