Unintended consequences, par excellence

The law of unintended consequences is not kind. It will strike wherever it pleases and sometimes even in places you wouldn’t expect. In an ironic twist, the order-to-trade ratio (OTR) may not calm markets as intended but reduce average trade size even further.

The OTR, or some variation of it, is used by many exchanges to manage their message load. Generally speaking, OTR counts the number of messages sent to an exchange relative to the number of executions triggered. The principle behind it is this: traders are invited to send as many messages as they like, as long as they create executions. Obviously traders do not have full control over the likelihood of execution, but they can influence this by making limit prices more aggressive or by allowing orders to stay in the order book. Currently, mention of the OTR (or the corresponding cancellation rates) has found its way into some of the latest draft legislations, such as MiFID II and the German HFT law. Regulators fear that increased message load will increase the risk of disorderly markets and result in growing infrastructure costs without benefit to the general market. Thus, they want to allocate costs associated with increased message loads to the originators.

However, regulators should carefully consider their next steps. As the following example illustrates, a maximum OTR restriction does not calm markets but instead reduces the average trade size and increases the system load. Let’s assume that you run an HFT market making strategy and you are required to adhere to a maximum order-to-trade ratio. All orders created by your strategy can be divided into two different buckets. Firstly, you have the ‘may-trade’ bucket. It includes orders you have sent to the exchange, but which you know you will amend in a very short time making the likelihood of execution very low. Secondly, you have the ‘must-trade’ bucket which contains all the orders that are very likely to execute once you send them to the exchange (for example, when your market making strategy has accumulated a large inventory and urgently needs to balance it).

Imposing a maximum OTR should give you an incentive to send only meaningful orders to the market. But, actually, it does more than that! The OTR gives you an allowance of order amendments and cancellations relative to executions. Thus, a market making strategy does not need to reduce the number of less meaningful orders, but simply to increase the number of executions achieved. This can be done by splitting any order from the ‘must-trade’ bucket into as many small orders as possible. Instead of sending one ‘must-trade’ order with 50 shares, send 50 ‘must-trade’ orders, each for 1 share, simultaneously.

It’s rather ironic. While many buy-side institutions already complain about small trade sizes, disciplining electronic market makers with an OTR may very well reduce average trade sizes further still.

One Response to “Unintended consequences, par excellence”
  1. Christian Voigt says:

    I had some interesting discussions with my colleagues on the OTR and its incentives. Firstly, it is worthwhile to point out that trading strategies do not necessarily work with buckets as suggested in the text. This is just something I used to illustrate my point. Instead of talking about ‘may-trade’ bucket or ‘must-trade’ bucket, you can also say passive or aggressive trades. Or simply said, a strategy can reduce its OTR by splitting up its aggressive orders. Secondly, as a result of splitting all your aggressive orders, the absolute number of messages necessary to execute the same amount of business will increase. To make matters worse the increase in messages is not equally distributed across the day. Spikes of multiple messages simultaneously hitting the exchange will become more frequent and pronounced.

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