CFA research finds no duplicate liquidity

17-Dec-2015

By Wouter Klijn

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CFA Institute research has found no evidence of high-frequency traders (HFT) artificially propping up liquidity in global equity markets.

Some investors have criticised HFTs for placing multiple orders with the intention of cancelling the majority of these orders before they can be executed.

This ‘testing’ of the market comes at the expense of other investors, these critics say.

CFA Institute capital markets policy analyst Svi Rosov studied the dynamics and characteristics of liquidity across equity markets in the United States, United Kingdom and France between 2010 and 2014.

But Rosov found no evidence of liquidity evaporating in large caps.

“Investment professionals are concerned that displayed liquidity is unrepresentative of the true ability to execute trades,” he said.

“The argument of these professionals is that HFTs post numerous duplicate limit orders to increase the probability of execution because they know they have the speed advantage necessary to cancel the unnecessary duplicate orders before execution.

“The study estimated the extent to which depth at the top of the order book may be composed of duplicate liquidity by examining the impact of a trade on the order-book depth in terms of a multiple of the trade size.

“The study found no evidence that the trade impact in the United States has changed between 2010 and 2014.

“With the immediate trade impact found to be zero, this finding reflects the deep liquidity of US markets.”

But he found some evidence the trade impact in the dominant UK lit venue, the London Stock Exchange, had worsened over time.

“Liquidity is being replaced more slowly in 2014 than in 2010-2012,” he said.

Yet overall, the findings suggested the state of liquidity in modern markets, as measured by most traditional metrics, was good, he said.

ASIC recently published a report that found no adverse effects from HFTs on the Australian market.

Rosov argued liquidity problems caused by HFTs were less likely in the Australian market because it only had two exchanges.

“While ASIC’s review didn’t find systematic market dysfunction, it raised concerns about the characteristics of latency arbitrage, phantom liquidity and market fragility in the broader context of historically low trading costs,” he said.

“However, associated timescales, and lack of quality data and natural experiments around these issues, make it impossible to empirically demonstrate any market-wide problems.

“Also, these issues affect mostly institutional investors, who have become increasingly sophisticated in their order submission strategies and there’s a growing sense that the debate is shifting away from HFT towards the disadvantages of a complete fragmentation of the market, particularly in the US.

“It’s the mismatch in communications infrastructure between the different venues that allows the existence of these unpopular strategies; the relatively benign findings of ASIC’s review could be explained by the less fragmented nature of the market outside the US.”

The issue of duplicated liquidity by HFTs and the cost of this to investors was brought to the attention of a wider public by author Michael Lewis in his 2014 book, Flash Boys.

Last weekend, Lewis backed the efforts by IEX to become a public exchange in the US, which he said would protect investors against the predatory trading of HFTs by introducing an intentional delay in the execution of trade orders.

“It's been interesting to read the public accounts of the money and time spent by high-frequency traders and the existing public stock exchanges to lobby your agency and other government officials to prevent IEX from becoming a public exchange,” he said in a submission to US regulator the Securities and Exchange Commission on Saturday.

“That is, to prevent an honest competitor from introducing an innovation into the US stock market that promises to benefit not only investors in that market, but the entire US economy, at the expense of high-frequency traders and the existing public stock exchanges.”

He argued that if IEX was allowed to become a public exchange, then it would further reduce the “tax levied by Wall Street intermediaries” on US stock market investors and introduce “a new spirit of fairness to that market”.

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