Inspecting Artificial Liquidity
Will Psomadelis, Head of Trading, Schroders Australia and Stuart Baden Powell, RBC Capital Markets discuss the effects of artificial liquidity providers on the trading costs, speed of trading and market structure.
Stuart Baden Powell: We have all read and heard a range of industry opinion about HFT over the previous few quarters, be it from HFT themselves, from investment banks who provide services to HFT or execution venues who are part owned by HFT and happy to create pricing mechanisms such as the ‘maker taker’ or specific order types to attract HFT-type flow. Some banks view the HFT servicing part of their electronic trading desk as a tool for market share gains where commission charges are negligible, yet the payback is the benefit of increased control of liquidity and the boost to corporate business.
Execution venues are frequently judged on market share, but perhaps genuine value-added to the price formation process (not just the spread), reliability and overall liquidity quality should also be factored in. Bringing these points together, a question to pose is what the purchase price for Chi-X Europe would have been if it were itself publicly traded, exposed to full analyst transparency and recommendations, or even not principally owned by investment banks and HFT?
Dropping a level, practice-based publicly available knowledge on HFT is still limited. ESMA has noted the primary techniques being “usually either quasi market making or arbitraging”, some would note that the arbitrage could refer to an evolution of ‘non high frequency statistical arbitrage’, others would add latency and rebate arbitrage to the mix. Either way, these are mere high level descriptives and are not representative of what happens underneath; like algorithms it is not the flyer or website description that is key and like many things in life, it is the details and depth that matter. One of those details discussed in more cutting edge circles is the concept of artificial liquidity.
Will, you run a trading desk for a highly respected institutional fund manager; could you talk us through what artificial liquidity is about and how it impacts on you and the market?
Will Psomadelis: Thanks Stuart. Artificial and natural liquidity, being polar opposites in terms of the quality spectrum, are the result of two different strategies and are generally characterised by differing trade durations (or holding periods). Natural liquidity providers are generally investors that deploy capital in the market to extract a return from an underlying business. These include traditional long-only funds, retail, hedge funds and some fundamentally driven quant funds that invest for periods longer than a few minutes.
Artificial liquidity providers (ALPs) ignore company fundamentals and therefore make their decisions on metrics such as price momentum, correlations or by extracting a return through rebates or commissions to name a few. Market maker liquidity is a prime example of this type of churn that is held up as the Holy Grail by some regulators and the one that I believe doesn’t improve our transaction costs. Whilst arguments have been made that the retail investor can benefit from increased churn courtesy of HFT artificial liquidity primarily through tighter spreads, we should remember that no market-wide benefit can be extracted as spread compression is a zero sum game.
It can be then argued that increased artificial liquidity, which is what we are seeing globally, contributes to the deterioration of price discovery. When market volumes are dominated by trades that have no fundamental basis, stocks can move independently of underlying fundamentals. Empirical evidence shows that stocks now tend to overshoot fundamental news (X.F. Zhang, 2010), ultimately detracting from market efficiency and adding to volatility.
At the institutional order size level, remembering we are really just representing pools of retail investors, we can add to the points discussed above our belief that HFT cannot reduce market impact. The typical institutional order will usually have an order duration of greater than the entire holding duration of a position by a market maker, meaning every trade where we are trading against artificial liquidity, creates a competitor…..
At some point during the duration of the institutional order, the market maker will need to cover their position and therefore compete for stock. This is a real issue when ~70% of volumes are HFT in nature (Tabb Group, 2010 on the US market). Put simply, in the absence of someone willing to withdraw capital from the market at price, it is impossible to inject capital without incurring market impact, even if millions of shares are being churned around you during a game of high frequency ‘pass the parcel’.
The fact that market makers vanish in situations like the Flash Crash and create liquidity vacuums proves that natural investors should not be relying on them for liquidity as liquidity is not really what they provide. Non-predatory artificial liquidity may not necessarily add cost in theory, but it also cannot improve our transaction costs.