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 ....