First of all, what is high frequency trading? It is the practice of using computers to generate order messages and send those messages to electronic exchanges at high speed (or “ultra-low latency” in industry parlance).

However, the growth of high frequency trading has exposed a major flaw in the structure of the equities markets. A flaw that many feel is now being abused, to the advantage of high frequency traders and the disadvantage of everyone else. The flaw is basically in the way that the exchanges allow HFTs to send what are in effect false bids and offers to the market.

By sending these false bids and offers, but “pulling” them before they have a chance to be executed, it could be argued that the high frequency traders are actually manipulating the markets, “tricking” other traders into showing their hand.

On any given day on the Nasdaq for example, executed volume might be around a billion shares. However, orders displayed on the order book throughout the day might be anywhere from 80 to 100 billion shares. So 99% of the orders are being shown on the order book and subsequently cancelled. Only 1% of visible orders are actually getting filled! A significant proportion of that 99% can be attributed to high frequency traders, sending orders and subsequently canceling them in an attempt to move stock prices in their favour.

So what can be done? Banning cancellation of orders is totally impractical and would adversely affect the market as a whole. However, if a disincentive to canceling orders was introduced in the way of a cancellation tax, the high frequency trading activities would be vastly reduced and many argue that this would be to the overall benefit to the market and to the wider investing public.

It certainly makes sense and seems to be a good way of preventing any potentially deceptive behavior in the markets on the part of the high frequency traders.

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