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 issue.
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 flawed regulation.