Academic journal article Chicago Fed Letter

A New Approach to Stock Market Execution

Academic journal article Chicago Fed Letter

A New Approach to Stock Market Execution

Article excerpt

The proposed introduction of CHX SNAP is a response to changes in market technolog)' that have provided an increasing advantage to the fastest market participants and led to the rise of HFT firms that often exploit their speed advantage to trade ahead of large orders placed by institutional traders. This has a tendency to make institutional traders more reluctant to display large orders to the marketplace, thus reducing liquidity. In this Chicago Fed Letter, we discuss the purpose and operation of SNAP auctions in the high-frequency trading environment.

HFT firms are market participants that have invested heavily in technolog)' and algorithms that allow them to trade at high speeds and in large volumes. They typically make many small trades in a day and hold limited, if any, positions overnight.

HFT firms use a variety of strategies in pursuit of trading profits. Co-location, whereby their servers are placed near the servers of exchanges, allows these firms to gain access to and process information about trades ahead of the broader market. They are then able to trade ahead of large orders placed by traditional investment firms and money managers. "If a high-speed firm's computers detect a large buy order for a stock ... the firm will instantly start snapping up the stock, expecting to quickly sell it back at a higher price as the investor keeps buying."2

Another strategy used by HFT firms is spoofing, "a form of market manipulation which involves placing certain non-bonafide order(s) ... with the intention of triggering another market participant to join or improve the NBBO [national best bid or offer], followed by canceling the non-bona-fide order, and entering an order on the opposite side of the market."3

Some have argued that HFT is often not about market fundamentals, but "a game against order books and the market rules."4 This game has increased the gains accruing to the fastest market player, leading to an escalating arms race for speed.

The race for speed can lead to an inefficient allocation of resources; "one can certainly question how socially useful it is to build fiber optic or microwave networks just to trade at millionths or billionths of a second rather than thousandths of a second."5 This arms race can also increase market fragility by increasing "the pressure on the plumbing of the system to handle ever-increasing speeds and message traffic."6

In a market environment frequented by HFT firms, slower market participants, whose larger orders are vulnerable to front-running and other HFT strategies, face a competitive disadvantage and may "withdraw from markets or seek other venues, fracturing liquidity."7 Budish, Cram ton, and Shim (2013) show that the race for speed leads to wider spreads and thinner markets for institutional investors because of the risk that liquidity providers face of having stale quotes picked off by faster market participants.8

SNAP auctions occur with minimal information leakage to the market and force competition on price rather than speed, which should reduce the risk fundamental traders face of having HFT firms move prices against their orders and the need to engage in the race for speed.

SNAP cycle overview

Throughout the trading day, market participants will be able to place orders to start or participate in a SNAP cycle for a particular security. Upon the receipt of a valid start SNAP order, CHX will notify the market that a SNAP cycle has begun and accept orders for execution within the SNAP cycle. At the end of the order acceptance period, CHX will rank all SNAP-eligible orders on its books to determine the SNAP auction price, the price at which the most buy and sell orders can be executed. If protected bids or offers at better prices exist on other stock exchanges, CHX will route orders to those exchanges to execute. Remaining orders will execute within the CHX SNAP book at the SNAP auction price. After orders have been matched, the SNAP cycle will end and CHX will transition back to regular trading in the security. …

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