High Frequency Trader Regulation

How to regulate High Frequency Trading Activities by considering their impacts on Market Quality?

Executive summary

After flash crash in the US stock exchange happened in May 6 2010, regulators start to focus on the activity of high frequency trading because potential risk brought by such activity. This report tend to discuss how to regulate the high frequency trading (HFT) by considering the HFT activities' impacts on market quality. More specifically, the majority of existing literatures suggest that HFT has positive impact on market quality. On the other hand, some arguments focus on the potential systemic risks arising from the HFT activities, such as suddenly liquidity withdrawal, etc. Therefore, this report focuses on the HFT activities' impacts on market quality and furthermore talk about the regulation of HFT activities on that basis.

Introduction

On May 6, 2010, the Dow Jones Industrial Index (DJIA) and other Indices experienced a sharp drop followed by an immediate recovery of a significant part of these losses. After this event, market participants were fast to accuse high frequency traders for it. Even this is no consensus that HFT leads to the crisis. However, while it seems that their behavior may have contributed to the crash (Kirilenko et al. 2010). From regulators’ perspective, it is important to guarantee that exchange market are under a healthy environment, therefore, it is really worth for them to consider how the activities of high frequency trading should be regulated.

HFT activities and Market Quality

1. HFT activities' positive effect on Market Quality

Most of existing literatures support that high frequency trading improves market quality, especially concerning the important market quality parameters, such as increasing liquidity and lower short term volatility (Hasbrouck and Saar, 2010, Brogaard, 2010). Consistent with their arguments, Cvitanic and Kirilenko (2010) find that the presence of the high frequency trader is likely...