As announced in its activity agenda for 2015, the Netherlands Authority for the Financial Markets (AFM) conducted an in-depth investigation into the trading strategies of high-frequency traders (HFTs) and their interaction with the trading infrastructure. As part of its investigation, the AFM documented the criticisms levelled at high-frequency trading, and studied two criticised trading strategies. The AFM is publishing the results of this investigation today.

Its conclusion is that the identified trading strategies are derived from traditional earnings models such as market making and arbitrage. The AFM recognises, however, that the fragmented stock market landscape and far-reaching use of technology in trading poses a real challenge to obtaining a reliable understanding of liquidity, especially for large investors. For example, it increases the difficulty for pension funds and unit-trust funds to limit the price impact as much as possible when having large orders executed.

Literature studies and discussions with stakeholders were employed to analyse the phenomenon of apparent liquidity by HFTs. In addition, data analyses were performed to assess whether HFTs can predict where liquidity of other market parties will occur in order to make use of it for their own ends.

Investigation into ‘apparent liquidity’

As a result of new applications of technology in the market infrastructure and at market parties, order books can change rapidly today. An investor thinks he can enter into a transaction, but is unable to do so because orders seem to disappear suddenly. Investors perceive this phenomenon as apparent liquidity and blame it on the trading practices of high frequency traders. The typical trading behaviour of some high-frequency traders is to often amend or cancel orders. Such volatile orders can mislead investors. In the AFM’s point of view, the rapid and frequent amending or withdrawing of orders is an essential feature of a common earnings model known as market making.

Investigation into ‘liquidity spotting’

Another often heard criticism concerns the trading strategy of high-frequency traders in which they could predict on the basis of partial executions of orders, mostly of large investors, where liquidity will occur. According to critics, HFTs then buy or sell liquidity on other investor trading platforms pre-empting investors. HFTs can then close out the position with the original investor as counterparty at a more favourable price. Through such actions by HFTs, investors would pay more for a purchase or receive less for a sale.

The AFM analysed the trading practice by HFTs in connection with the execution of five large orders on Dutch and English trading platforms. Within the Netherlands’ jurisdiction, it was not shown in these orders that HFTs were able to ‘spot’ liquidity.

Basis of the investigation

As part of its investigation, the AFM spoke with various high frequency traders, as well as with representatives of pension funds and trading platforms. An analysis of the supervisory data was also carried out to identify possible instances of criticised trading practices. The results of the investigation have been shared with the relevant market parties, and refined if the need was apparent. With this investigation, the AFM hopes to contribute to the debate on high-frequency traders and the current market structure. In this context, it is collaborating with academics, other supervisors, ESMA (European Securities and Markets Authority) being one of them, and the market parties.

 

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