## Friday, July 10, 2015

### The changing landscape of equity markets

by Nidhi Aggarwal and Chirag Anand.

The arrest of a London based algorithmic trader, Navinder Singh Sarao, on charges of triggering the US flash crash of 2010 has once again brought regulatory concerns on high frequency trading (HFT) to the forefront. With the underlying fear that the use of high speed complex algorithms can pose systemic risk, regulators worldwide are considering actions to tighten their grip on HFT. The Indian securities markets have not remained immune to such concerns, and the securities market regulator, SEBI, has indicated that steps will be taken to keep the level of algorithmic trading (AT) in check. Very recently, even RBI in its annual Financial Stability Report expressed its concerns regarding high levels of algorithmic orders in the Indian securities market.

Despite all the fears and the measures that are being taken to curb HFT, one needs to note that the evidence regarding how HFT (or AT) hurts the market is yet to be established. Concerns such as higher percentage of algorithmic orders creates higher level of systemic risk in the financial system are not backed by strong empirical evidence. Studies examining AT/HFT trading only find evidence contrary to this popular notion (Brogaard et al., 2015; Thomas and Aggarwal, 2014). Other studies (Biais and Faoucault, 2014) examining the overall effect of AT/HFT on market quality find that higher levels of AT/HFT improves market quality by increasing liquidity and price efficiency. In spite of this overwhelming evidence on the effect of AT, regulatory fears on how increased market complexity can disrupt the financial markets remain.

An analysis at the Finance Research Group, IGIDR aims to provide a few insights on the proliferation of HFT (or AT) in the Indian markets. Using a unique tick by tick orders and trades dataset from one of the most liquid stock exchanges in the country, the National Stock Exchange (NSE), we examine how AT/HFT has changed the equity market structure in India. In addition to the usual details of price and volume, the data contain details of whether an order was sent by an AT or a non AT, and whether the order was a new order, or an old order that was modified or cancelled. A clear demarcation of orders sent by AT versus non AT, enables us to examine the characteristics of how AT's trade in the markets vis-a-vis non AT.

We analyse two periods: a low AT period (November-December 2009) and a high AT period (November-December 2013). Few points emerge:

• Between the two periods, percentage of orders entered by algorithmic traders increased from 11.36% to 62.76% on equity spot, from 38.93% to 93.72% on single stock futures (SSF), and from 21.29% to 86.79% on single stock options (SSO).
• On the most liquid segment of NSE, that is the Nifty options, the percentage of new orders entered by AT increased from 19.60% to 93.56%.
• On Nifty futures contract, it increased from 21.57% to 91.23%.

The values indicate that a large proportion of the orders that are entered on NSE today are by algorithmic traders (AT). A majority of these orders are limit orders, indicating that instead of going for the special orders that the exchange offers, AT prefer the traditional limit orders which offer them greater flexibility to manage their orders.

### Do AT supply liquidity or demand liquidity?

The increase in percentage of AT orders in the market raises the concern on whether that increase corresponds to a similar increase in liquidity supply, or, whether they consume liquidity from non algorithmic traders. For each segment on NSE, we analyse the percentage of trades in which AT supplied liquidity versus the trades where they demanded liquidity. When an order that comes to the market trades against an existing order in the book, the new order is said to have taken (demanded) liquidity, while the existing order is said to have provided (supplied) liquidity.

The graph above indicates the share of AT orders in total liquidity demanded increased across all the segments between the two periods. However, this matches with their share of orders in total liquidity supplied to the market in all except the Nifty options market. We further break this analysis into who supplies liquidity to whom. This is depicted in the following graph.

In the above graph, the top-left panel indicates the percentage of trades in which AT demanded liquidity from another AT. On the spot market, for example, AT took liquidity from other AT in 6.34% of trades in 2013. The top-right panel indicates the percentage of trades in which non AT demanded liquidity from AT. The bottom left panel indicates the percentage of trades in which AT demanded liquidity from non AT. Finally, the bottom right panel indicates the percentage of trades in which non AT demanded liquidity from non AT.

A difference in the values in the bottom right panel from 100 indicates the AT-intensity, that is the percentage of trades that occurred on NSE in which AT was either on one or both sides of the trade. For example, on the spot market, in 2013, the percentage of trades in which AT were present atleast on one side of the trade was (100 - 44.3)% = 55.7%.

Of particular interest are the top-right and bottom-left graphs. These two graphs indicate non AT demand for liquidity from AT, and AT demand for liquidity from non AT, respectively. The values in the graph reinforce the observation that AT demand as much liquidity from non AT as they supply to them for all except the Nifty options market.1 This suggests that the concern that AT consume liquidity from non AT does not hold.

We now proceed on to examining how the order placement strategies of AT have changed the market structure on NSE.

### Changing market structure due to high speed access

Q:1 How have order placement strategies changed after faster market access? With a majority of the orders coming from AT, we first examine if there has been a change in the order placement strategies by market participants. Specifically, we examine if the increase in the number of orders has translated into a larger number of trades, or are most of the orders that are entered are eventually cancelled?

The table below indicates the percentage of orders that get traded and cancelled by AT and non AT.

 All values as % of total orders entered Spot SSF SSO Nifty futures Nifty options 2009 2013 2009 2013 2009 2013 2009 2013 2009 2013 AT 12.42 62.19 39.18 93.30 20.56 84.89 11.11 87.84 21.71 93.38 Traded 3.91 12.37 1.59 2.20 0.74 2.61 3.02 7.73 1.49 7.47 Cancelled 8.31 49.73 37.52 90.91 19.65 82.03 7.99 79.88 20.15 85.88 Non AT 87.58 37.81 60.82 7.70 79.44 15.11 88.89 12.16 78.29 6.62 Traded 56.11 25.69 14.17 3.00 24.95 6.03 45.37 8.18 32.76 4.43 Cancelled 21.75 7.24 44.88 3.20 44.05 6.52 39.67 2.70 43.22 1.63

The first row in the table indicates the percentage of orders entered by AT. As discussed eariler, the share of AT in the total number of orders sent to the NSE has risen significantly. The second row in the table indicates the percentage of AT orders that got traded.

The table shows that the increase in percentage of new orders entered by AT is not matched with a higher percentage of orders that got traded. Instead, we see a decline in the percentage of traded orders across all the five segments (spot, SSF, SSO, Nifty futures, Nifty options). For example, on the spot market, the percentage of orders that got traded declined from 60.02% in 2009 to 38.06% in 2013. We also find a significant increase in the percentage of orders that got cancelled in the high AT period (2013). Of the total unique orders that came to NSE, the percentage of orders that got cancelled increased from 30.06% in 2009 to 56.97% in 2013 on the spot segment, from 82.40% to 94.11% on the SSF and from 63.70% to 88.55% on the SSO. On Nifty futures, this percentage increased from 47.66% to 81.58% and on Nifty options from 63.37% to 87.51%.

While there could be legitimate reasons for such cancellations (Hasbrouk and Saar, 2009), the increase in the percentage of cancelled orders raises concerns about phantom liquidity (also known as spoofing, flickering quotes, or fleeting liquidity), that is, the fear that high speed access allows the trader to post an order for everyone to see, but withdraws it before anyone can act on it. We examine this concern in the next question.

Q:2 Do order cancellations occur at very short intervals? Higher percentage of order cancellations, by itself is not a matter of concern. The concern instead is that these orders might be getting cancelled in such short a time that other traders, who do not have the advantage of fast market access, are unable to execute their orders against such orders. Or, these orders could be sending signals of false liquidity. In order to pin down these concerns, the evidence of cancellations needs to be combined with evidence of speed of cancellations - or the lifespan of the orders. If a majority of the orders are cancelled in very short time intervals, then it could be suggestive of phantom liquidity in the markets.

 Cancelled orders as a percentage of total orders entered on Nifty options Cancelled orders as a percentage of total orders entered on SSF

The graphs above indicate the percentage of orders that got cancelled in less than a second on the two most liquid NSE segments: Nifty options and single stock futures (SSF). The graphs suggests that in the high AT period (2013), more than 70% of the orders entered on the SSF and about 54% of the orders entered on the Nifty options market got cancelled within a second.2 These values are substantially higher than the values in the low AT period of 2009, during which 7.83% and 14.96% of orders got cancelled within one second on SSF and Nifty options.

A useful question to ask is how these numbers compare with the global markets. A similar analysis for the US equity markets by SEC indicates that 45.9% of the orders were cancelled within a second during Q2 2013.3

Q:3 Is fast too fast? The analysis above indicates that high speed access has made cancellations too fast. The next question that becomes important to ask is, Is this too fast''? To characterise the intensity of what is fast, we use the SEC's approach. In a speech in April 2014, by the then Associate Director of SEC, Gregg Berman, noted:

If the speed of cancellation is much quicker than the speed at which those quotes can be accessed, then I would say quote cancellations are not only fast, but perhaps they are too fast. However, if market participants can lift quotes just as quickly as others can cancel them, I would say that the cancellations might be fast, but not necessarily too fast."

And its relevance in informing the policy debate:

If quote cancellations are indeed too fast for the rest of the market to keep up, it might make sense to slow down this particular aspect of the markets, perhaps with some sort of minimum quote-life requirement. But it the data shows that at least some market participants can access quotes just as quickly as they can be canceled, this suggest that both sides of the market are very fast and if you want to slow down the market -- in a way that does not bias one side, you would need to not only address the speed of quote cancellations, but also the speed at which liquidity is taken."

We examine this by comparing the lifespan of cancelled orders with that of the traded orders. We once again restrict our discussion to the two most liquid segments on NSE: Nifty options and SSF.

The graph above shows the results for Nifty options for cancelled (top-panel) and traded (bottom-panel) orders. A shift from the red to yellow region indicates increase in the speed of order cancellations or execution. In 2009, while about 30% of all cancelled orders remained in the book for less than a second, about 55% of all traded orders were the result of some trader hitting limit orders within that same time period. These numbers rose to 65% and 80% respectively in 2013. Also noticeable is that the number of modifications on these cancelled orders is in the range of 0-5. This suggests two features of trading activity on the Nifty options market:

1. A majority of the orders that get cancelled do not undergo large number of modifications.
2. Access to speed has indeed increased the speed of order cancellations, but this speed is lower than the speed of execution.

The Nifty options inferences do not however hold for the SSF. In 2009, the percentage of cancelled orders within a lifespan of less than a second on SSF was almost negligible, while the percentage of traded orders within the same lifespan was less than 40%. The numbers changed dramatically in 2013. The graph shows a shift from red to yellow region for cancelled orders, but only a shift from red to orange region for traded orders. The percentage of cancelled orders with a lifespan of less than a second was about 75%, while the percentage of traded orders within the same lifespan was about 45%. This indicates that the speed of order cancellations surpassed the speed of trade executions in 2013.

## Summary

In a nutshell, the findings can be summarised as:

1. The share of algorithmic orders in total orders that come to the market has risen significantly.
2. Except for the Nifty options market, the share of algorithmic traders in liquidity demand matches with their share in liquidity supply.
3. A large majority of the orders on NSE are cancelled, with most of them occurring within a second of order entry.
4. The speed of order execution is higher than the speed of order cancellations on Nifty options. This is however not true of the SSF segment of the NSE.

The above analysis does imply that the order placement activities have changed significantly with a lot of cancellations occurring within short time-frames. However, to analyse whether this degree of cancellations could be hurting the other market participants, it is critical to examine the where these quote cancellations occur? If most of these cancellations are occurring around the best bid and ask prices (or even the upto level 5 depth of the market), such cancellations could be a cause of concern. Further analysis aims to capture this aspect.

### References:

High-frequency trading and extreme price movements by Brogaard J, Carrion A, Moyaert T, Riordan R, Shkiklo A and Sokolov K, 2015, Working Paper

The causal impact of algorithmic trading on market quality by Susan Thomas and Nidhi Aggarwal, 2014. IGIDR Working Paper.

HFT and market quality by Biais B and Foucault T, 128, 2014 in Bankers, Markets and Investors, p. 5-19.

Technology and liquidity provision: The blurring of traditional definitions by Hasbrouck J, Saar G, 2009. Journal of Financial Markets, Volume 12, Issue 2, May 2009, p. 143-172.

### Footnotes

1. The reason for the difference in the nature of AT liquidity demand and supply on the options market needs further investigation.
2. We record similar values for the rest of the market.
3. The findings are also comparable to studies investigating fleeting orders. For example, Hasbrouck and Saar (2009) find that 36.69% of the limit orders get cancelled in less than two seconds on INET.

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.