Rise and Fall of High Frequency Trading in China

Background Information

Definition of High-Frequency Trading

High-frequency trading (HFT) is loosely defined as a type of algorithmic trading characterized by high speeds, high turnover rates, and high order-to- trade ratios that leverages on high-frequency financial data and electronic data tools. As a result, HFT related strategies are built based on high speed access to markets and infrastructure that allow rapid analysis of signals as well as correspondingly execution of orders.

Difference between Algorithm Trading and High-Frequency Trading

HFT is a relatively newer phenomenon in the AT landscape and typically involve rapid updating of orders and intra-day trading periods. The rapid submission of cancellation and deletions is necessary to realize small profits per trade. HFT focuses mainly on high liquid instruments and seek to generate return through provision and control of liquidity as well as various arbitrages.

Summary of HFT Strategies

1) Passive market making Leveraging on its high-speed infrastructure, passive HFT strategies include passive market making where firm provides liquidity by matching buyer and seller orders instantaneously. They profit on the difference between the bid-ask spread and are reportedly driven by the firm’s receipt of so-called liquidity rebates (usually a fraction of a penny a share) and the stock exchange they are posting orders to.

2) Arbitrage trading Arbitrage trading is profiting from price differential for the same or related securities listed on multiple exchanges. It involves placing simultaneous buy and sell order to diminish the price differential between exchanges, in the process profit from the temporal inefficiencies of our financial market.

3) Momentum Ignition Momentum ignition is a strategy in which a proprietary trading firm initiates a series of orders aimed at causing rapid up or down securities price movements through rapid erecting and cancelling of buy or sell walls. Shops employing momentum ignition can benefit from price movement triggering stop losses or spoof algorithm of other traders into action to trade more aggressively. However, legality of spoofing is still widely debated and varies in different countries.

4) Order Anticipation Order anticipation, also known as detection trading, involves traders using computer algorithms to identify equity dark pool through submission of exploratory orders. Proprietary traders work on this information to trade ahead of the realization of equity dark pool to market price.

High Frequency Trading in China

HFT of single stocks has not been very well received in China due to 1)delayed settlement of stock transactions, 2)500ms black box limits HFT algorithm and 3)exorbitant transaction fees

T+1 Settlement for stock transactions

Stock transactions in China are cleared on a T+1 basis which makes it difficult for high frequency trading since shares bought on T=0 can only be sold on T+1.

Current black box for index and option order book In China, orders are transmitted in a 0.5s interval which creates a throttle on the high frequency algorithm designed to leverage on milliseconds order book changes. The existence of the 0.5s black box limits the frequency of trade and compresses profitability of HFT in China compared to the United States.

High transaction fees for stock transactions Transaction costs inclusive of stamp duties and commissions tend to range between 0.1%-0.4% of trade value which further erodes the already razor thin profit margin operations. Consequently, most of the HFT action in China is in the futures and options market.

Consequently, majority of the HFT action revolves around the China futures and derivative market instead. In Oct 2014, the average daily volume of CSI futures traded doubled year-on-year.

China's stance towards HFT

Legislation pertaining to High-Frequency trading The Securities Law of the People’s Republic of China is enacted to standardize the issuing and trading of securities, protect the lawful rights and interests of investors, safeguard the economic order and public interests of the society as well as promote development of the socialist market economy. After its inception in 2004, revisions were made in 2005, 2013 and 2014. Among which, there has been no significant difference as to what the State considers as forbidden trading activities. The China Securities Regulatory Commission (CSRC) prohibits insider trading, market manipulation, misappropriation of fund and authority as well asdisruption of securities market through dissemination of false information.

Based on the securities act, the fundamental concept of HFT is not illegal in China’s securities market. In fact, passive HFT strategies help promote efficiency and liquidity in the Chinese capital market which aligns with the State’s current direction. However, more aggressive HFT strategies such as momentum ignition, borderlines on market manipulation through rapid erection of buy and sell offer to spoof the market. Furthermore, aggressive strategies tend to add volatility which goes contrarian to the State’s ideal of stable growth.

Historical Intervention by China Securities Regulatory Commission

Crackdown on Yishidun (伊世顿) - Sentenced on 23 June 2017 China handed down a $101 million penalty and two suspended prison cases in its first criminal case against a high-speed trading firm. Yishidun was fined 300 million yuan for manipulating China’s futures markets and ordered to disgorge 389 millions in profits. The proprietary trading shop, controlled by two Russians, illegally plugged its trading system into the Financial Futures Exchange in early 2015 and capitalized on the speed advantage gained to trade futures on the CSI 300 and 500 indexes. Yishidun was able to place orders at an average turnover of 0.03seconds with trades settling at twice the standard deviation from market price compared to the top five algo-trading teams in China. Furthermore, suspicions of market manipulation with self-filling orders surfaced when news reported that they transacted the largest number of sell orders despite its relatively small size. However, Yishidun denied accusations of market manipulation and affirmed that the punishment was due to the illegal speed advantage it obtained over other traders since the fine imposed by the court was at the lowest end of the options available to it.

The case had been closely watched by the trading community as it provides information of Chinese authorities’ stance on high-frequency trading.

Suspension of Algorithm traders post 2015 stock market bubble- Suspended on August 3 2015 Following the popping of stock market bubble on 12 June 2015, the CSRC suspended 38 trading accounts claiming that they had influenced securities prices or investors decisions for personal gains. They believe that these accounts were engaged in practice known as spoofing which contributed to the increased volatility during the crash. Among which, trading account operated by the brokerage arm of US hedge fund Citadel has been suspended.

Tightening control on speculative trades post 2015 stock market crisis The 2015 Chinese stock market crash began with the popping of stock market bubble on 12 Jun 2015. The SSE fell by almost 50%, consequently pressuring the Chinese government to lower volatility through tighter regulations on speculative trades.

Post-intervention, total value of SSE50, CSI300 and CSI500 futures traded plummeted 99.5%, 99.3% and 97.4% respectively due to higher transaction cost and maintenance margin. To put things in perspective, high frequency traders in the United States only incur 0.00001% in transaction fees coupled with a much lower maintenance margin.

Increasing control on commodities futures trading In 2016, speculators piled into futures contract for steel and nonferrous materials, betting that a rise in infrastructure spending would push price higher. Rebar future prices on the SSE in November 2016 were 70% higher than at the beginning of the year. Nervous about speculation and inflation, the state intervened by raising transaction fees on rebar futures by 500% and margin deposit requirements for steel and nonferrous materials by 1% to 9% of total contract value. As a result, volume of commodity futures trading in China has plummeted by 30% in the first 3 quarters of 2017.

Moving forward

It is unlikely that high frequency trading of equities will happen considering the current T+1 settlement system for stock transactions and 2)500ms transmission black box that throttles HFT algorithm. Moving forward, with the loosening of control on futures and options, it is possible that HFT will make a comeback in the booming mainland market. Quant funds have been stress-testing the validity of practicing both HFT and statistical arbitrage strategy to generate returns around the trade limit regulation. Despite the relatively stricter control compared to the pre-2015 era, we remain bullish on the prospect of HFT in China and abilities of quant to surprise us with better strategies. After all, they are the infamous Alchemists of Wall Street.