High Frequency Trading (HFT), through systematic computer based algorithms by gauging market movements and eventually acting upon pre-defined protocols, has become a popular mode commodity derivatives trading. Such techniques initially introduced in fixed income, currency, and equity markets are now increasingly being applied to trading in bullion, energy, and the agricultural commodities. HFT has contributed to a surge in the number of trades in NYMEX crude from under 1 million in 2005 to almost 42 million in 2011, and in CBOT corn from 133,000 to 10.7 million.
Indian commodities markets have not lagged far behind either. Ever since the regulator formally approved algorithmic trading in May 2008, HFT/AT attained significant prominence in the India commodity futures market. Yet, apprehensions with HFT remained in various circles including regulators. It has often been hypothesized that HFT may not have the beneficial impacts that it is supposed to have (by providing liquidity, thereby smoothening the exit and entry barriers), but can destabilize the markets by increasing volatility. Such apprehensions are not always out of ground. Internationally, there have been thoughts that HFT can destabilize markets as the “ask” or “bid” orders might arrive at substantially huge volumes, for the market to really withstand. A distinct incident is the May 6, 2010 flash crash, during which the Dow Jones Industrial Average fell by over 600 points in 5 minutes, only to recover almost all its losses in the next half hour. More so, after the publication of Michael Lewis’ seminal work in this domain, Flash Boys: A Wall Street Revolt, the concerns are turning out to be in a different direction. Incidentally, HFT in contracts of small denominations (or mini and micro-contracts) were suspended from trading in the Indian commodity derivatives markets on the basis of this apprehension in January 2013. Subsequently, however, HFT in the mini-contracts has been allowed, and right now, the Exchange, as self-regulatory organization has to exercise the caution. Definitely, this is a wise move by the regulator!
The author of this article, along with few co-researchers, recently carried out an econometric analysis on the impacts of HFT on market quality for the Indian commodity derivatives markets. Market quality, in this context, was defined by liquidity, volatility, and hedging efficiency. As such, the prime utility of HFT should ideally arise from providing liquidity to the market; however, it has also been allegedly convicted for increasing volatility. Worldwide, there are mixed evidences on both counts. The commodities contract selected were Gold, Copper, Nickel, Zinc, Silver, Aluminium, Lead, Copper, Nickel, Silver, Zinc, Aluminium, and Lead from the base metals complex, while in the agricultural commodity complex, Crude Palm Oil (CPO), Mentha Oil, Potato, Cardamom, and Cotton, were chosen. Interestingly, for all the commodity contracts, it was found that HFT increases liquidity, except for the Aluminium mini contract and the agricultural commodity contracts. On the other hand, with the exception of the aluminium mini contract, HFT was not found to be having any impact on volatility. However, the impacts of HFT on hedging efficiency remained inconclusive from this exercise.
This exercise revealed a few interesting pointers about the impacts of HFT in Indian commodity exchanges, especially in a scenario when there is apprehension about the need for such trading. Aluminium mini is a low-volume (or less “liquid” than any other international commodity) contract in the Indian commodity exchanges, as compared to the other contracts. Due to thinness of the market, HFT has not played any significant role in liquidity enhancement. This further brings out the conclusion that generally for commodity derivatives contracts that attract a good volume, HFT can increase liquidity, and has not created any destabilizing impact on the market. Rather, to enhance their beneficial role in the long-run (through improvement of long-run market efficiency), HFT needs to be encouraged in the contracts that satisfy such volumetric conditions.
(Nilanjan Ghosh is Chief Economist at Multi Commodity Exchange of India Limited. The views are personal).