The myth of order cancellations: a new study

20 January 2016


It is sometimes said that high frequency traders aren’t really providing liquidity to the market because they cancel orders more frequently than other market participants. A new research paper shows that this really isn’t true. The paper finds that the order cancellation ratios of non-HFT firms are “almost identical” to HFT firms. The reason is simple: the technological improvements used by HFT firms are now permeating through the marketplace. As the paper says, all trading is now fast, and all types of market participants are updating their orders much more rapidly.

The research paper, written by Avanidhar Subrahmanyam (University of California, Los Angeles) and Hui Zheng  (The University of Sydney ), uses data for 116 stocks listed on Nasdaq to examine the liquidity provided by high-frequency traders compared to non-HFT participants. The data consisted of all order messages and transactions in Nasdaq's limit order book, time-stamped down to the nanosecond level. Some of the inspiration for this study appears to be the concerns around order cancellation behaviour in automated trades and their impact on liquidity. As limit orders are an important source of market liquidity, and recent research has suggested that HFT firms are more likely to supply liquidity via limit orders than non-HFT, understanding ‘HFT behaviour’ around this order type is crucial to understanding the overall picture.

The study’s findings run counter to rhetoric about liquidity being illusory or hard to access from electronic market makers, bringing the following conclusion:

“Our results show that the limit order cancellation ratio is almost identical between HFT firms and non-HFT firms. The sizes of limit orders are also similar between the two groups. The average time a limit order rests on the LOB is shorter for the limit orders of HFT firms, but the absolute time to execution and time to cancellation are also very short for non-HFT limit orders and in many cases they are not much longer than those of HFT firms. Overall, our results confirm the recent comments of O’Hara (2015, p. 9) that “all trading is now fast, with technological improvements originally attaching to HFTs permeating throughout the market place,” and question the effectiveness of some regulatory proposals targeting HFT.”

The report also highlights the benefits to the markets of high frequency trading technology allowing rapid order cancellations. As automated trading methods and HFT technology allow traders to receive and process large amounts of information very quickly, they are able to make very accurate prices. By using HFT technology to update orders, these firms manage their own risk and contribute to better price formation than traditional methods are able to provide. This is a distinct advantage of electronic liquidity provision for the markets, as the better-informed the orders are in the Limit Order Book, the better the quality of the market.  

The authors of the paper did not analyze the trading behaviors of “non-HFT” traders, but in our experience, the technology of high-frequency trading is now widely used by many sophisticated market participants, such as investment banks, hedge funds and asset managers. Our hope and expectation is that further research will confirm this observation. But this should not be a surprise. The innovative technologies associated with HFT are valuable to all traders, and it is only a matter of time before these innovations diffuse to every corner of the financial markets.

The study concludes with a plea to regulators to ensure that they understand and consider the benefits that HFT technology has brought to the markets, when deliberating over new regulations. This echoes the sentiments of a paper from the Toulouse School of Economics, which alerts regulators to the potential for loss of market liquidity as an unintended consequence of curbing order cancellation behaviour through Order to Trade Ratios (MiFID II).

These two studies both make a very simple point: technology has fundamentally changed the way our markets operate, not just for the firms identified as HFTs -- “All trading is now fast, with technological improvements originally attaching to HFTs permeating throughout the market place.”[1] Academic papers such as these are ideally placed to help regulators better-understand the new and complex picture we are all working with; ensuring that new regulations are well-informed and help markets to operate in a better and forward-looking way. As with price discovery, better-informed regulation will also improve market quality, which will benefit all participants and end investors.


[1] O’Hara, M. (2015). "High frequency market microstructure." Journal of Financial Economics 116(2): 257-270

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