Examining 'Phantom Liquidity' and the Cost of HFT Regulation
By Dr. Hui Zheng, The University of Sydney and Capital Markets CRC
Originally published on TABB Forum
Some market participants have long argued that the liquidity provided by HFT traders is illusory and difficult to access. But recent research concludes that HFT limit orders exert a stabilizing influence on markets, calling into question the effectiveness and rationale of recent regulatory proposals targeting high-frequency trading.
The recent high-profile court cases in the U.S., U.K. and China on high-frequency trading (HFT) have further elevated the concerns about HFT. In particular, a core issue in the ongoing debate is the impact of HFT on market liquidity. Some market participants have long argued that the liquidity provided by HFT traders is illusory and difficult to access, which has been dubbed as “phantom liquidity.” Using a unique dataset with a complete history of limit order placement, execution, and cancellations on NASDAQ, Dr. Hui Zheng, Senior Lecturer at the University of Sydney and Senior Researcher at the Capital Markets CRC, has, for the past 2 years, been working with Prof. Avanidhar Subrahmanyam from UCLA on a joint research project, the first study to date focusing on the liquidity provision by HFT traders.
The study shows that HFT firms more effectively use order cancellation to strategically manage their limit orders in anticipation of short-term price movements. HFT firms increase their liquidity provision during periods of high volatility; their liquidity provision is less affected by order imbalance shocks. Overall, the study finds that HFT limit orders exert a stabilizing influence on markets, and provides an explanation to the unfavorable impact of new policies adopted in Canada and Italy that universally curbed all HFT activities.
The results of the study have strong policy implications. The study finds that the cancellation ratio and the size of limit orders are very similar between HFT and non-HFT firms. The time that limit orders sit on the limit order book is very short for both HFT and non-HFT firms. These results confirm that “all trading is now fast, with technological improvements originally attaching to HFTs permeating throughout the market place” [O’Hara, M. (2015). “High frequency market microstructure.” Journal of Financial Economics 116(2): 257-270]. The study also finds that the limit order placement behaviors of HFT and non-HFT firms are consistent with their respective economic purposes of trading. These results question the effectiveness and rationale of some recent regulatory proposals targeting HFT.
Recently, Martin Wheatley, CEO of the Financial Conduct Authority, stated that, “A priority challenge for HFT specifically, which I’m not sure has yet been honestly assessed by all players, is where the balance lies between the potential benefits against costs.” The study by Dr. Zheng and Prof. Subrahmanyam provides vital perspectives for market regulators to consider when assessing the overall costs and benefits of HFT regulation.
Read the full research paper, “Limit Order Placement by High-Frequency Traders,” below.