by Michael Aitken, Douglas Cumming and Feng Zhan


While the issue of optimal market design is not the sole responsibility of the regulator, regulators play a special role in such decisions because they are the parties charged with the task of authorizing market design changes. Their mandate dictates that they convince themselves that any market design change must pass the dual test of fairness and efficiency before it is authorized. Notwithstanding that security market regulators are required under their respective mandates from national governments to ensure that the markets they oversee are fair and efficient, there is comparatively little empirical evidence to guide regulatory decisions. As a result, debates about the pros and cons of issues such as high frequency trading (HFT) are driven largely by opinion rather than evidence.
If indeed this is the situation, one might justifiably ask why we are still debating the pros and cons of HFT, which in the U.S. now reportedly accounts for more than 60 percent of total trading. Surely the regulators must in meeting their mandates have demonstrated that HFT enhances, or at the very least, does not detract from, the fairness and efficiency of markets. The alternative— which is scary—is that regulators have authorized changes to the marketplace without reference to how that change enhances fairness or efficiency of the market. In the knowledge that all market structure changes are dogged by the same issue, one can’t help wondering whether the process by which regulators authorize changes is adding to rather than solving the problem. While one might forgive a regulator dealing with a first-time change, at best authorization of such a change should be temporary while they investigate the implications for fairness and efficiency in light of the change.
Given that HFT has been a phenomenon of U.S. markets for several years, surely U.S. regulators must now be in a position to provide that evidence and in the process assist regulators around the world with similar decisions. The fact that the SEC held a market structure conference in Washington, D.C., in October 2012 that offered little clarity on the issue of how HFT affects the fairness and efficiency of markets leads one to ask, why is this situation persisting?
In our recent work,1 we define and produce operational measures of market fairness. We empirically show across 22 exchanges around the world that exchanges in which HFT exists exhibit higher levels of market fairness. Market fairness is defined as the extent to which market participants engage in prohibited trading behaviors. In our work, we develop a proxy for market manipulation (and therefore fairness) by identifying dislocation of the end of day price. In particular, we measure the frequency of end-of-day price dislocation manipulation cases, as well as the trading value surrounding such manipulation cases. Moreover, we measure dislocation of the end-of-day price around three particular events that are more likely to be manipulation, including end-of-month/quarter (when portfolio managers may have incentives to move the price around), index rebalancing, and option expiry dates. 
We argue that HFT provides greater liquidity and price discovery in a marketplace, and this market improvement mitigates traders’ ability to dislocate the end-of-day price. We provide evidence consistent with this proposition; namely, that dislocation of the end-of-day price is much less likely and the trading value surrounding such dislocation cases is much smaller in markets that have HFT. Our evidence is robust to controlling for a number of other factors that could affect manipulation, including differences in trading rules across countries and time, and other market differences. Further, we show robustness to numerous econometric methods and empirical tests.
Our paper is the first to provide an empirical assessment as to whether HFT has a positive effect on market fairness. Taken together with the existing evidence that HFT reduces transactions costs and enhances price discovery,2 the usual proxies for market efficiency, we demonstrate not only how market fairness can be operationalized, but how it can be used in market structure decisions.
In summary, only by defining and measuring both fairness and efficiency can sensible market structure decisions be taken. Decisions currently are being made without reference to empirical evidence, which not only explains why we seem to be going round and round in circles on issues like HFT, but it also makes one wonder about the long-term outcomes of such decisions.


1) Cumming, Douglas J., Feng Zhan, Michael J. Aitken, 2012. “High Frequency Trading and End-of-Day Manipulation,” Available at SSRN:
2) Hendershott, Terrence, and Ryan Riordan, 2012, “High Frequency Trading and Price Discovery,” working paper, University of California, Berkeley.