High-Frequency Trading in the FX Market

High-Frequency TradingHigh-Frequency Tradingin the FX Marketin the FX Market

Yoshiharu SatoYoshiharu SatoUniversity of Warsaw, 2015University of Warsaw, 2015

(https://sites.google.com/site/yoshi2233/)(https://sites.google.com/site/yoshi2233/)

FX Market StructureFX Market Structure

・・ Before 1990's, the FX market was predominantly a broker-Before 1990's, the FX market was predominantly a broker-dealer market restricted to large financial institutionsdealer market restricted to large financial institutions

・・ Most transactions took place in the inter-dealer core of this Most transactions took place in the inter-dealer core of this market, and customers were able to trade only in the outer market, and customers were able to trade only in the outer tier of this market with wider spreadstier of this market with wider spreads

・・ Requests for quotes and transactions were typically doneRequests for quotes and transactions were typically doneover the telephoneover the telephone

・・ Advent of electronic broking/trading in 1990's brought Advent of electronic broking/trading in 1990's brought about a revolution in the inter-dealer market, still the about a revolution in the inter-dealer market, still the boundary between the core and customers remainedboundary between the core and customers remained

FX Market StructureFX Market Structure [1] [1]

FX Market Structure (cont.)FX Market Structure (cont.)

・・ In early 2000's, the boundary between the market core and In early 2000's, the boundary between the market core and customers blurred as FX dealing banks started offeringcustomers blurred as FX dealing banks started offeringelectronic trading services to clients. Today the market has electronic trading services to clients. Today the market has become less dealer-centric, to the point where there is become less dealer-centric, to the point where there is no longer a distinct inter-dealer-only marketno longer a distinct inter-dealer-only market

・・ The FX market is now a huge decentralized OTC marketThe FX market is now a huge decentralized OTC marketwith $5.3 trillion turnover a day, trading 24h/5days a week. with $5.3 trillion turnover a day, trading 24h/5days a week. 70% of the spot currency volume is now algorithmic, and 70% of the spot currency volume is now algorithmic, and 30-35% of the volume is by HFTs [2]30-35% of the volume is by HFTs [2]

・・ Currency volume shares: USD 85%, EUR 40%, JPY 20%,Currency volume shares: USD 85%, EUR 40%, JPY 20%,GBP 13%, AUD 8%, CHF 7%, etcGBP 13%, AUD 8%, CHF 7%, etc

FX Market Structure (cont.)FX Market Structure (cont.) [1] [1]

FX Market Structure (cont.)FX Market Structure (cont.) [2] [2]

Advantages of FX HFTAdvantages of FX HFT

・・ The highly liquid, 24h open FX market is ideal for HFT,The highly liquid, 24h open FX market is ideal for HFT,which requires a liquid underlying market in order towhich requires a liquid underlying market in order tomake profits from a large number of small tradesmake profits from a large number of small trades

・・ Co-location (i.e. HFTs moving their servers as close asCo-location (i.e. HFTs moving their servers as close aspossible to the trading venue) allows HFTs to trade with possible to the trading venue) allows HFTs to trade with latency of less than 1 millisecond, compared with 10-30mslatency of less than 1 millisecond, compared with 10-30msfor most non-HFT participantsfor most non-HFT participants

・・ HFTs can therefore react very quickly to various profitHFTs can therefore react very quickly to various profitopportunities that exist in the FX marketopportunities that exist in the FX market

Who are FX HFTs?Who are FX HFTs?

・・ HFTs in the FX market are mostly proprietary trading firms, HFTs in the FX market are mostly proprietary trading firms, some of which have evolved from HFT in equities. Others some of which have evolved from HFT in equities. Others have been developed by existing FX specialists that have have been developed by existing FX specialists that have decided to move into the HFT spacedecided to move into the HFT space

・・ FX HFTs concentrate in Chicago, New York and LondonFX HFTs concentrate in Chicago, New York and London(where co-location facilities are primarily located) and(where co-location facilities are primarily located) andtrade mainly on inter-dealer electronic platforms (EBS, trade mainly on inter-dealer electronic platforms (EBS, Reuters) and ECNs (e.g. Currenex, Hotspot, Fxall)Reuters) and ECNs (e.g. Currenex, Hotspot, Fxall)

・・ Since HFTs typically access the various platforms via their Since HFTs typically access the various platforms via their prime brokers, other participants can usually see only the prime brokers, other participants can usually see only the prime brokers’ names and not their clients’ namesprime brokers’ names and not their clients’ names

Who are FX HFTs? (cont.)Who are FX HFTs? (cont.)

・・ FX HFTs tend to focus on spot of the most liquid pairs FX HFTs tend to focus on spot of the most liquid pairs

・・ Larger FX HFTs are the predominant source of interbank Larger FX HFTs are the predominant source of interbank liquidity in the FX market and tend to trade on EBS/Reutersliquidity in the FX market and tend to trade on EBS/Reuters

・・ Smaller FX HFTs prefer ECNs due to lower minimum trade Smaller FX HFTs prefer ECNs due to lower minimum trade size, less trading controls, and full anonymitysize, less trading controls, and full anonymity

・・ Since HFT strategies require a diverse, information-rich Since HFT strategies require a diverse, information-rich (multi-bank, multi-price) environment, many FX HFTs trade (multi-bank, multi-price) environment, many FX HFTs trade on multiple platforms for greater market coverage and on multiple platforms for greater market coverage and circumventing certain platform constraints (e.g. number of circumventing certain platform constraints (e.g. number of quotes that can be submitted per second)quotes that can be submitted per second)

FX HFT StrategiesFX HFT Strategies

・・ Classic arbitrage: exploits the difference between the Classic arbitrage: exploits the difference between the market price and the implied no-arbitrage pricemarket price and the implied no-arbitrage price(e.g. triangular arbitrage)(e.g. triangular arbitrage)

・・ Latency arbitrage: exploits the small time lag between Latency arbitrage: exploits the small time lag between when market-moving trades take place and when market-when market-moving trades take place and when market-makers update the prices they quotemakers update the prices they quote

・・ Liquidity-providing: earns a spread by exploiting order Liquidity-providing: earns a spread by exploiting order book imbalances for a particular currency pair and pricing book imbalances for a particular currency pair and pricing discrepancies across trading platformsdiscrepancies across trading platforms

・・ Complex event processing: exploits various propertiesComplex event processing: exploits various propertiessuch as momentum, mean-reversion, correlation (with such as momentum, mean-reversion, correlation (with other currency pairs or with other assets) and responseother currency pairs or with other assets) and responseto economic data releasesto economic data releases

Event Reaction – ExampleEvent Reaction – Example [3] [3]



FX HFT Strategies (cont.)FX HFT Strategies (cont.)

・・ The majority of HFT strategies are designed to benefit from The majority of HFT strategies are designed to benefit from high liquidity and low volatility. Hence there is a tendency high liquidity and low volatility. Hence there is a tendency for HFTs to avoid illiquid currency pairs and reduce trades for HFTs to avoid illiquid currency pairs and reduce trades when volatility riseswhen volatility rises

・・ Given their high-volume, low-margin trading style, HFTs Given their high-volume, low-margin trading style, HFTs typically are highly sensitive to the impact of even small typically are highly sensitive to the impact of even small trading errorstrading errors

HFT Impact on FX MarketHFT Impact on FX Market

・・ Due to the intense competition brought about by HFTs, Due to the intense competition brought about by HFTs, spreads has been narrowed and liquidity has been spreads has been narrowed and liquidity has been increased in normal market conditionsincreased in normal market conditions

・・ Price behavior has become more granular, with fewer big Price behavior has become more granular, with fewer big moves and gaps than inmoves and gaps than in the days of manual-only tradingthe days of manual-only trading

・“・“ Increased liquidity” is still debatable – HFTs send large Increased liquidity” is still debatable – HFTs send large numbers of orders and cancellations (i.e. quote stuffing), numbers of orders and cancellations (i.e. quote stuffing), and their orders appear simultaneously in multiple trading and their orders appear simultaneously in multiple trading venues but disappear across venues as soon as one of venues but disappear across venues as soon as one of them is hit (a.k.a. liquidity mirage)them is hit (a.k.a. liquidity mirage)

FX HFTs during Flash CrashFX HFTs during Flash Crash

・・ On May 6, 2010 (Flash Crash), algorithmic traders On May 6, 2010 (Flash Crash), algorithmic traders (including HFTs) comprised 53.5% of total activity in FX,(including HFTs) comprised 53.5% of total activity in FX,which was higher than 2010 average of 45%which was higher than 2010 average of 45%

・・ This suggests that FX HFTs did not reduce activity duringThis suggests that FX HFTs did not reduce activity duringthe Flash Crash unlike equity HFTs, who paused trading the Flash Crash unlike equity HFTs, who paused trading and caused the liquidity in the equity market evaporatedand caused the liquidity in the equity market evaporated

FX HFT vs Equity HFTFX HFT vs Equity HFT

FX HFT vs Equity HFT (cont.)FX HFT vs Equity HFT (cont.)

・・ They both tend to focus on the most liquid market segmentThey both tend to focus on the most liquid market segment- Index futures, ETFs, blue-chip stocks- Index futures, ETFs, blue-chip stocks- EUR/USD, USD/JPY, GBP/USD- EUR/USD, USD/JPY, GBP/USD

・・ They have similar impact on marketsThey have similar impact on markets- Narrower spreads- Narrower spreads- Smaller quote size, shorter quote life- Smaller quote size, shorter quote life- Shorter holding time, more frequent trades- Shorter holding time, more frequent trades

・・ They raise common concernsThey raise common concerns- Liquidity mirage- Liquidity mirage- Hot-potato trading volume- Hot-potato trading volume

・・ FX HFT is increasing in trade volume sharesFX HFT is increasing in trade volume shareswhile equity HFT has decreased due to scrutinywhile equity HFT has decreased due to scrutiny


・・ Rebate arbitrage – a prevalent HFT strategy in equitiesRebate arbitrage – a prevalent HFT strategy in equities

・・ Local exchanges offer rebates to liquidity providers Local exchanges offer rebates to liquidity providers (passive limit orders) while charging liquidity takers(passive limit orders) while charging liquidity takers(active market orders) a.k.a. the Maker-Taker model(active market orders) a.k.a. the Maker-Taker model

・・ The HFT captures the rebate fee each time an order results The HFT captures the rebate fee each time an order results in a passive trade, regardless of whether the trade makes in a passive trade, regardless of whether the trade makes profits or not. But if the HFT trades actively to reduce a profits or not. But if the HFT trades actively to reduce a position by either hitting a bid or lifting an offer, it does not position by either hitting a bid or lifting an offer, it does not obtain the rebateobtain the rebate

・・ This type of pure market-making HFT strategy is so far not This type of pure market-making HFT strategy is so far not prevalent in FXprevalent in FX


・・ Latency arbitrage – another HFT strategy in equities made Latency arbitrage – another HFT strategy in equities made prevalent by the 2005 SEC Regulation NMS, which requires prevalent by the 2005 SEC Regulation NMS, which requires brokers to execute each customer trade at the national brokers to execute each customer trade at the national best bid or offer price (NBBO) across all US equity best bid or offer price (NBBO) across all US equity exchanges at that given momentexchanges at that given moment

・・ The time lag between the appearance of bids/offers on the The time lag between the appearance of bids/offers on the raw price feeds from various exchanges and the posting of raw price feeds from various exchanges and the posting of the NBBO on consolidated data feeds provides a potential the NBBO on consolidated data feeds provides a potential arbitrage opportunity for HFTsarbitrage opportunity for HFTs

・・ This exists in FX, but there is no equivalent of NBBO andThis exists in FX, but there is no equivalent of NBBO andlatencies are less predictable as FX is decentralized with latencies are less predictable as FX is decentralized with less transparency than equitiesless transparency than equities

ConclusionsConclusions

・・ FX HFT originated from equity HFT. It is important toFX HFT originated from equity HFT. It is important tounderstand the commonalities and differencesunderstand the commonalities and differences

・・ HFTs are normally beneficial in providing liquidity and HFTs are normally beneficial in providing liquidity and narrowing spreads, but given its sensitivity to risk, HFT narrowing spreads, but given its sensitivity to risk, HFT liquidity may evaporate rapidly in stressed circumstancesliquidity may evaporate rapidly in stressed circumstances

・・ HFT is an embodiment of the operational advantage gained HFT is an embodiment of the operational advantage gained by superior technology. Once this advantage has been by superior technology. Once this advantage has been gained, it is difficult for others to compete away this gained, it is difficult for others to compete away this advantage, given the large investment required to replicate advantage, given the large investment required to replicate the technologythe technology

ReferencesReferences

[1] Bank for International Settlements, “High-frequency trading in the foreign [1] Bank for International Settlements, “High-frequency trading in the foreign exchange market,” 2011.exchange market,” 2011.

[2] Bank for International Settlements, “The anatomy of the global FX market [2] Bank for International Settlements, “The anatomy of the global FX market through the lens of the 2013 Triennial Survey,” 2013.through the lens of the 2013 Triennial Survey,” 2013.

[3] https://twitter.com/nanexllc/status/608778936743522304[3] https://twitter.com/nanexllc/status/608778936743522304



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High-Frequency Trading in the FX Market