SBP: That is intriguing Will and should open several pairs of eyes. You mentioned empirical research; there has been a lot of opinion on HFT, yet limited valid and reliable empirical research exists. Frank Zhang’s piece is now supported by further research from Columbia and Cornell Universities who note that HFT activities “move the market price away from the fundamental value and increase the return’s volatility (as well as) market volatility” (Jarrow and Protter, 2011). This is of course contrary to the views of many sellside and execution venues.
Another point is regarding the market share numbers of HFT. In Europe, many lean on the widely accepted 35% of the overall market number. AFME recently released an insightful study into the OTC Market in Europe to follow the UK version conducted by TABB Group (in part using AFME data). The report noted that approximately 60% of “all MiFID OTC equity trades were duplicate trades” or “reporting events” such as give ups/ins and principal trades and were thus “non-executable”.
The key point here is that this non-executable business should now be stripped out of the divisor for the market share calculation for HFT. Indeed as the TABB report itself notes “it is the executable liquidity that is most relevant and points to the true size of the market”. If we take the TABB piece as an example and strip out its own non-executable OTC numbers from the total size of the market, HFT in the UK is no longer 35% of the ‘true’ market but rather in reality higher than 50%. This is a sea change and one that could reset understanding and impacts.
Will, parts of Asia are experiencing their own execution venue competitions. What are the key points that can stimulate artificial liquidity and is there anything the buy-side can do to combat what must be a cost?
WP: The primary objective of a stock exchange should be to provide a stable platform for sellers and buyers to trade. Unless the incumbent exchanges are working at capacity (which they aren’t) or gouging prices then the entrance of a new exchange cannot increase the number of natural liquidity participants as there are no existing capacity constraints. By definition, new exchanges that promise to improve liquidity can only really stimulate the ‘artificial liquidity’ we mentioned earlier.
New exchanges are mostly citing speed as their advantage, under the pretence that speed itself increases liquidity and efficiency. Microsecond trading should not be a focus of a capital investor so, in essence, the only people that need ultra low latency to generate returns are artificial liquidity providers or – if we look at these participants more cynically – those taking advantage of information opportunities.
Whilst new exchanges may have lowered the explicit costs for brokers and improved their margins, these savings can be matched or exceeded by the implicit costs the buy-side may incur through the most cynical strategies that seem to flourish in this new environment. If new exchanges mostly bring artificial liquidity then the buy-side has to change its behaviour. Clearly, the best way to reduce market impact is to find another investor willing to extract capital that you are willing to inject (or vice versa). Block trading through the upstairs market (sales traders and block dark pools) is therefore the cheapest way to trade at an implicit price level.
Fong, Madhavan and Swan (2002) show that the ‘upstairs market’ is ‘pareto improving’ as investors’ trading blocks can reduce their market impact at no increase in total cost to other market participants. That’s right, block trades are a net benefit to the market! In essence, as artificial liquidity can’t actually reduce transaction costs on block volumes, the buy-side community needs to realize that working ‘over-the-day’ orders is not the lowest cost alternative they think it is (QSG, ‘Beware the VWAP trap’, Nov 2009). Block volume trades should be manufactured in the upstairs market or traded in block dark pools to reduce interaction with churn. The upstairs market needs to become the primary weapon in the buy-side trader arsenal to kill transaction costs and improve efficiency at the block trade level.
SBP: As a final word, a lot of people are talking about ‘intended’ and ‘unintended’ consequences in relation to HFT and/or any pending regulation. As Scottish economist Adam Smith himself noted “it is not from the benevolence of the butcher or baker that we expect our dinner”, “but from their regard to their own self interest”. Smith went on to state that “we are led by an invisible hand to promote an end which has no part of his intention”. That end is self-interest.
With that and concepts such as artificial liquidity in mind, there is a genuine need for regulators and the buy-side to be cognizant of those points when engaging with members of the industry. Both should move deeper into the inner mathematical workings to unpack HFT trading techniques. Understanding this will help answer the question of whether HFT really does feed the market with liquidity or rather deters natural liquidity, harms the end investor and increases the fragility of a fracturing market micro structure.
Inspecting Artificial Liquidity
