New CFA Institute Study Examines the Impact of High Frequency Trading on Market Quality and Adverse Selection: Are Investors Getting Rolled Over?

A new study by CFA Institute, Liquidity in Equity Markets: Characteristics, Dynamics, and Implications for Market Quality, finds that market quality is high, trading costs are historically low, and liquidity supply is generally resilient, dispelling some of the popular concerns about the state of modern markets. However, a closer inspection of market structure identifies the lack of diversity of liquidity provision as a potential problem in the long run. The study also suggests that a move toward enforcing larger tick sizes in the US may undermine efforts to boost liquidity on lit markets.

Liquidity in Equity Markets investigates two recurring investment practitioner complaints. Firstly, the perception that contemporary market structure has increased the “adverse selection” problem, whereby high frequency traders (HFTs) divert their trading to dark venues during stable market conditions, before switching to lit markets just as prices begin to move. This often leaves investors using limit orders on lit venues on the wrong side of the market.

Secondly, the study investigates the perception that displayed liquidity does not represent the true ability to execute trades. This may arise, for example, when HFTs post numerous duplicate limit orders to increase the probability of execution because they know that they have a speed advantage which enables them to cancel the unnecessary duplicate orders before execution.

Dr Svi Rosov, CFA, analyst, Capital Markets Policy at CFA Institute and author of the study, analysed data from 50 large and small cap stocks from the US, the UK and France (150 stocks in total), looking at trading and quote data for every stock on 48 days from 2010 to 2014. The study finds evidence to suggest that participants on lit venues are adversely selected against – in this case, picked-off by informed traders when the quote rolls. This phenomenon is most evident in the US where the proportion of off-exchange trading when the quote is stable is almost double that of unstable periods. The report argues that over time, this may erode the incentives to participate on lit venues.

However, this finding should be considered in the context of historically low trading costs in large cap stocks. Small cap stocks suffer from higher trading costs, but even these are low by historical standards. The study does not find any evidence of systematic liquidity duplication across all the markets which were analysed. Liquidity supply is generally instantaneously replenished, suggesting the market is resilient at the top of the order book.

Dr Rosov commented:

“The data show that spreads, be they relative, depth-weighted or effective, are at historically low levels in the US, UK and France. In the US we see spreads to as low as one tenth of their level in 1999 for both large and small caps. Further, for large caps, the sizes available at the top of the order book are roughly double what they were in 1999. Small cap sizes, meanwhile, are little changed. 

“In the UK and France, since 2010, depth-weighted spreads for a 25,000 GBP/EUR transaction have also declined. It is hard to argue for wholesale changes to market structure on this basis.

“Despite this seemingly rosy picture of modern market structure, there are concerns that high-frequency market-makers are so efficient at what they do that no other type of market participant can compete with them. This makes the limit order book more homogenous, with less diversity of liquidity supply, which in turn means that there is an increased risk that during times of stress, market liquidity can evaporate very quickly.”

Liquidity in small cap equity markets in the US has been the focus of the Securities and Exchange Commission, with a pilot study of larger tick sizes due to be implemented in 2016 to test whether larger spreads create incentives for more market-making. Liquidity in Equity Markets suggests that a larger tick size may amplify the incentives to trade off-exchange by increasing the profitability of internalization strategies and exacerbating adverse selection risk, thereby imposing higher costs on investors.