Debate over the impact of high frequency trading (HFT) on Canadian equity markets got notably richer today, as the Investment Industry Regulatory Organization of Canada (IIROC) published three of the papers it has commissioned on the issue.
The regulator is careful not to signal any policy changes that may come as a result of the research. It is publishing the papers without any comment, saying that it intends to review, and discuss all of the papers internally, with other regulators, and with other market players, “before determining what, if any, regulatory response may be required in light of the findings.”
The papers come amid a market-led efforts to combat the perceived effects of HFT, including the forthcoming launch of the Aequitas NEO exchange, and proposed changes to the TMX’s trading model. Critics of HFT argue that these traders have an unfair speed advantage that can be exploited in ways that are detrimental to markets overall, and retail traders in particular.
However, there is little academic consensus on the empirical impact of HFT. Over the past couple of years, IIROC has been undertaking research into HFT to get an objective view of its role in the markets, and whether it gives rise to any regulatory concerns.
“Consistent with our commitment to transparency, we are publishing these highly anticipated academic papers that shed light on the impact of HFT on market integrity and quality,” said Wendy Rudd, senior vice president, market regulation and policy at IIROC. “We are releasing the papers promptly upon receipt to encourage an informed and fulsome dialogue among market participants and other stakeholders.”
One of the central questions surrounding the impact of HFT is its effect on market liquidity, and whether the liquidity it provides is durable in times of market stress. On that subject, the first paper, High Frequency Market Making to Large Institutional Trades, compares designated market makers (DMMs) and high frequency traders that act as market makers (HFTs) in terms of how they provide liquidity to large institutional trades. It finds that, “Both HFTs and DMMs provide liquidity to large institutional trades, with HFTs providing substantially more.” However, the researchers also say that, “In high volume stocks, HFTs reduce liquidity provision for ‘stressful’ trades by 42% while DMM liquidity provision remains mostly unchanged.”
The second paper, Market Integration and High Frequency Intermediation, studies the impact of HFT on market integration and fragmentation. It finds that “HFT are integral in tying markets together”; adding, “that HFT are responsible for the bulk of price discovery but that they are less important for liquidity.”
The third paper, The market quality effects of the 2012 UMIR amendments to the short selling rules in Canada, looks at the effects of the repeal of the “tick test rule” on short selling in Canada. It says that the change “resulted in a modest decline in volatility in medium and small stocks and in a modest increase in quoted spreads in large and medium stocks.” However, the researchers also found that “trading costs did not change discernibly. Neither did the components of trading costs. We conclude that the change in short selling regulation had a moderately positive effect on Canadian equity trading.”
Two more papers are still in the works as part of this research effort. IIROC indicates that it expects these papers to be published by the summer of 2015.
As for the papers published today, IIROC says that it is “exploring opportunities for the authors to present their findings”, and to facilitate debates about their implications in a public forum. In the interim, it is seeking comments on the papers. French versions of the papers will be published by Jan. 31, 2015, it notes. At the same time, IIROC says it’s also continuing to work on its own internal research on HFT.