Exchanges could combat high-frequency trading latency arbitrage by conducting very frequent batch auctions, according to academic research.
Eric Budish, associate professor of economics at the University of Chicago Booth School of Business, presented a paper on the topic at the European Capital Markets Institute’s Annual Conference in Brussels on 29 October. Sviatoslav Rosov, an analyst in the capital markets policy group at CFA Institute, a sponsor of the conference, wrote about the presentation on the institute’s blog.
Budish said in his paper that frequent batch auctions eliminate the arms race between firms as they spend millions to cut trading speeds by milliseconds, as auctions reduce the value of tiny speed advantages and change competition on speed into competition on price. “Consequently, frequent batch auctions lead to narrower spreads, deeper markets, and increased social welfare,” he added.
The paper argued that the continuous limit order book market design of most exchanges should be replaced by frequent batch auctions – uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals, e.g., every 1 second.
“First, and most centrally, batching substantially reduces the value of a tiny speed advantage and frequent batch auctions eliminate the purely technical cost of liquidity provision in continuous limit order book markets associated with stale quotes getting sniped,” wrote Budish. “Batching also resolves the prisoner’s dilemma associated with continuous limit order book markets, and in a manner that allocates the welfare savings to investors.”
Rosov pointed out that on his post that London Stock Exchange’s Turquoise platform operates a random auction. One of Turquoise’s order books, Midpoint Dark, includes Turquoise Uncross with random intra-day auctions which makes it harder for the venue to be targeted by aggressive trading strategies. For example, in a liquid stock the cross occurs randomly every five to 10 seconds while for a less liquid stock the random period can increase to between five and 45 seconds.
Last month Turquoise launched a Block Discovery function to allow firms can to send conditional orders into the random uncross, while continuing to search other liquidity pools, to make it easier to trade large deals.
Next year London Stock Exchange will also introduce a two minute auction every day for all Sets equities, the largest and most liquid shares traded on its markets, during which the continuous market will be stopped. The new auction will be at noon to match the current intra-day auction in Germany.
Brian Schwieger, head of equities at the London Stock Exchange said in a statement: “The introduction of the intra-day auction is in direct response to demand from buy-side participants for neutral, infrastructure-led solutions for trading in large blocks. We are aware that institutional investors hope it will encourage European markets to follow suit, creating over time a significant and harmonised pan-European focus for liquidity at midday across the continent.”
During the auction the London Stock Exchange will disseminate the most up to date indicative auction uncrossing price which will be updated whenever orders are added, deleted or modified. When the auction ends, the balance of buy and sell orders will be used to calculate the uncrossing price and continuous trading will start again.
Rosov write that at the conference Mark Hemsley, chief executive of stock exchange BATS Chi-X Europe, highlighted some problems with implementing frequent batch auctions. Hemsley said it is unclear how a discrete batch auction exchange would function alongside continuous time exchanges and that it is unclear how a frequent batch auction equity exchange would interact with a derivatives exchange.
“To get around the asynchronicity of price discovery between exchanges, all exchanges would have to become frequent batch auctions and have the auctions perfectly synchronised for the discrete-time auction model to work, in its strictest interpretation,” added Rosov.
According to Rosov, Budish argued that any frequent batch auction exchange would only be responsible for eliminating latency arbitrage on its own venue.
Johannah Ladd, secretary general of the FIA European Principal Traders Association said in an email to Markets Media that FIA EPTA believes there are significant issues that need to be resolved before frequent blind batch auctions could be implemented alongside continuous trading.
“We believe that the choice of the most suitable matching engine for specific products should not be regulator-directed, but instead should be directed by a free market system where, subject to the concepts of fairness and integrity, market participants are free to transact in a manner they choose.” she added.
Ladd said that blind batch auctions do not provide the most basic requirements in electronic exchange markets - certainty and immediacy - as investors cannot be sure of the the execution price.
“Under such a market design, liquidity providers would be forced to delay hedging until the next batch auction occurs,” Ladd added. “This longer holding period, even if measured in milliseconds, increases inventory risk as market participants cannot immediately hedge new inventory.”
Featured image via Brian Jackson/Dollar Photo Club