Edward Backes, Head of Market Supervision, Eurex Frankfurt AG, on why High-Frequency Trading is a good thing

1. Why high-frequency trading is a good thing
Edward Backes, Head of Market Supervision, Eurex Frankfurt AG
The recent market turbulence and unusually high volatility that came with it have again
directed wider attention to a particular group of trading participants: high-frequency traders –
that is, participants who place buy and sell orders in the order book with extreme frequency
and, in the vast majority of cases, do not have any open positions left on their books at the end
of the day. The popular perception is that price volatility would be significantly reduced if such
high-speed trading did not exist. The question is: Does the media paint an accurate picture and
is there any truth in headlines like “Profiteering from Stock-Market Turbulence”, “Automated
Panic”, and “High-Frequency Trading – Potential Devastator”)?
Several research institutions have recently examined high-frequency trading and published
extensive studies on the topic. Two examples are a study published in Britain by the
Government Office for Science in September 2011 called “The Future of Computer Trading
in Financial Markets,” and a study by the Goethe University in Frankfurt from April 2011
titled “High-Frequency Trading”. Both studies concluded that high-frequency trading is
being wrongly demonised. In fact, the central message of both studies is clear: Such trading
techniques actually increase liquidity and improve market quality.
As the operator of both cash and derivatives markets, we examined how accurate these
studies’ findings are – particularly in light of Eurex’s guiding principles of transparency, fair
price determination and orderly trading for all market participants. These principles apply for
all market participants, regardless of the trading technology and type of access used.
We used the market activity on 25 August 2011 as the basis of our own research. On this day,
the performance of the DAX Future (FDAX), which tracks the underlying DAX® index of
leading German blue-chip stocks, made the headlines. What had happened on that day? In the
span of 17 minutes, the FDAX fell by more than four percent and then rose again in the
following four minutes by two percent. The rumours circulating in the market afterwards
drew attention to the potential role of high frequency traders in the contract’s dramatic moves.

2. Our analysis generated some interesting results. First, the fall in the FDAX was triggered by
high volume orders of around 6,000 contracts by institutional clients (“buy side”), which were
entered into the trading system as sell positions in small batches with a view to “safeguarding
interests”. As shown in Figure 1, a price drop was not triggered by an illiquid market
situation. In fact, the high volume orders were processed with small price increments.
Average turnover increased in this period to more than 1,700 contracts per minute, far higher
than the monthly average of just under 300 contracts per minute. At the peak, as many as
4,700 contracts per minute were being traded – a clear sign of a highly liquid order book.
Figure 1: Trading in FDAX futures contracts on 25 August 2011 (one-minute intervals)
14000
5700
12000
5600
No. of traded contracts
10000
DAX index points
5500
8000
5400
6000
5300
4000
2000 5200
0 5100
15:45 15:50 15:55 16:00 16:02 16:05
Second, the turnover seen in this 20-minute period was generated by the activities of a wide
range of participants. A total of around 200 different participants acted as buyers in this
period (in a falling market), including but not limited to high-frequency traders. Around 170
different participants acted on the sell side. The detailed analysis indicates there were up to
122 different participants acting as buyers and 106 different participants acting as
sellers per minute (see Figure 2).
2

3. Figure 2: Number of individual buyers and sellers per minute
4000
4,710
67 Number of active market participants
3000
122
2000 97
108 95 104 87
99 95 97 104
101
86 88 103 110
1000 81
77
67
Contracts
69
70
0
55
61 55
74
-1000 73 79 67 83 84
73 82 83 88
74
87 80 83 86
-2000 83
106
-3000
-4,710
-4000
15:45 15:50 15:55 16:00 16:02
Third, the high market liquidity was in large part provided by the actions of the high-
frequency traders, as these participants initially absorbed the major sell positions and then
passed them on to protect the market. We have been observing this typical trading pattern for
quite some time. Moreover, the often assumed acceleration of downward movements through
computer-based trading strategies was not observed.
This ad-hoc analysis makes it clear: During times of market turbulence, regulated markets like
Eurex have consistently made valuable contributions to the fair and orderly readjusting of
investment strategies for short, medium and long-term investors thanks to their transparent
and reliable market infrastructure. We offer our participants sufficiently large liquidity pools,
even in volatile market phases. High-frequency traders also make a valuable contribution
here. They help in processing high volume orders in a way that protects the market by placing
a rapid succession of small, non-directional buy and sell orders, thus preventing abrupt price
movements. It can be demonstrated that participants who employ high-frequency techniques
3

4. serve as liquidity providers, alongside arbitrage investors and hedgers, i.e. participants
carrying out hedging transactions. Our analysis has shown that high volume sell orders in a
difficult market environment found a sufficient number of buyers, allowing them to be
processed in just a few minutes.
Nevertheless, it is essential from the point of view of a market operator to keep track of
changes in the market and technical innovations, and to react if necessary. With a view to the
increasing market share of automated trading strategies, Eurex built protective mechanisms
into the market structure some time ago. These deal with errors, whether they arise from a
mistaken entry (“fat finger”), a panic attack by an inexperienced trader, or an erroneous
algorithm. These mechanisms include, among other things, volatility interruptions, real-time
risk management and order limits. For example, volatility interruptions allow us to
automatically stop trading in individual products in response to unusually large jumps in price
triggered by mistaken entries, stop-order cascades or illiquid market situations. This gives
participants the opportunity to readjust their market assessment and order management before
trading restarts. A chain reaction, such as that seen in the U.S. flash crash, would have been
and is impossible at Eurex.
In summary: It is unfair and counterproductive solely to blame high-frequency traders for
volatile markets and major price fluctuations. At the same time, high-frequency trading
should only take place in an appropriate regulatory environment in which benefits and risks
are well balanced and sufficient consideration is given to both parameters. Minimum
requirements governing organisation and risk control are particularly important here. We
should refrain from over-regulating, however. This is damaging and encourages participants
to evade the rules and migrate to less stringently supervised trading venues, thus depriving
regulated stock and derivatives exchanges of important liquidity.
4