In recent weeks, high-frequency trading (HFT) skeptics have
turned their febrile imaginations to the issue of "excessively
high" order cancellation rates, suggesting they constitute
evidence of gaming or manipulation on the part of
HFTs, or proof that the liquidity these strategies
provide is of inferior quality. The fact that the detractors
never specify a rate of cancellations they'd deem satisfactory,
nor any material criteria for determining such a threshold,
belies the fact that cancellation rates are, in fact, a false
Cancellation rates in excess of 90 percent arise quite
naturally from the operation of perfectly legitimate and
valuable liquidity-providing strategies. For instance,
cross-sectional mean-reversion (i.e. the tendency of abnormally
wide spreads between correlated stocks to converge) is the
among the oldest and most widely practiced of all
liquidity-enhancing quantitative strategies. A common technique
for executing a mean-reverting spread trade is to post a bid on
a stock believed to be cheap, and then attempt to
actively hedge oneself by hitting the bid on another stock that
is reckoned to be "expensive."
The efficacy of such an approach depends on the continuous
availability of shares on the bid of the stock used as a hedge.
If shares on the bid of the hedging instrument disappear
(because the hedge ticked down), then the trader will seek to
cancel his bid on passive leg of his trade, since the effective
spread between the rich and cheap stocks will have changed.
Though such strategies can entail extremely high cancellation
rates, their value to the market is well-understood and
non-controversial, as they serve as effective mechanisms to
transfer liquidity from stocks where it is abundant to those
where it is in demand.
Claims that high cancellation rates are symptomatic of
low-quality liquidity are similarly spurious. Quite the
opposite is true elevated cancellation rates are
evidence of robust competition between market makers vying for
priority during the price-formation process. Most electronic
markets observe strict price-time priority. In such markets,
time priority at each price level is extremely important,
because it determines the extent to which an order is likely to
experience adverse selection when filled. Thus,
each time a new price is formed, liquidity providers rush to
submit orders to secure their place in line at the new price.
Participants who wind up at the end of a very large queue will
be more inclined to cancel their orders, in order to avoid
adverse selection. Discouraging such players from canceling
their orders will deter them from trying to compete for time
priority, which will result in far less competition among
market makers to participate in the formation of prices.
A common sleight-of-hand used by detractors to "demonstrate
the growing problem" of increasingly large cancellation rates
is to plot a time series of cancellation rates over the past
ten years or longer. These transparently cynical attempts to
pin blame neglect to mention that the growth in cancellation
rates is linked mostly to factors unrelated to HFT. One such
factor is the overall number of price changes per unit of time;
price changes lead naturally to cancellations, as traders must
cancel old orders in order to participate at current prices.
The frequency of price changes depends on the prevailing level
of volatility in the market, as well as the size of the minimum
quoting increment. Thus, it is entirely unsurprising (and not
at all the fault of HFTs) that upon the advent of decimal
pricing, cancellation rates show a huge and permanent spike
upward, and that during periods of heightened volatility (e.g.
2008-2009), cancellation rates temporarily surge as well.
Another important factor is increasing market fragmentation.
After the final implementation of Reg NMS in 2007, new
exchanges quickly proliferated, and there are over a dozen
exchanges that are now protected by Reg NMS. This
affects cancellation rates because a passive trader will often
post orders on multiple venues in order to maximize the odds of
getting filled. As a result, the total shares posted at a price
across all venues often significantly exceeds the amount that
traders are willing to buy or sell at that price. Consequently,
when a trader's allotted size is filled at some subset of
venues, he must cancel all open orders at the remaining venues.
The more such venues, the greater the cancellation rate.
Unsurprisingly, charts of cancellation rates over time show
another sharp and permanent shift upward shortly after the
passage of Reg NMS, but again, this has nothing to do with HFT
and everything to do with the fragmentation created by this