Page 1 of 2
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.