How high-frequency trading and market liquidity relate

Does high-frequency trading (HFT) increase market liquidity

High-frequency trading (HFT) is usually used in algorithmic trading for posting orders with an unbelievably high speed. Algorithms identify possibilities under which a huge number of superquick trades (measured in seconds or milliseconds) may bring income to their owners. Although HFT supporters state that it helps to increase the market liquidity and narrow down the Bid-Ask spread, many market participants believe that such an ‘improvement ’ of the market liquidity is of an illusionary character and HFT makes the market even more unstable and, as a consequence, unpredictable. In this article, we will discuss whether high-frequency trading increases market liquidity.

In this article:

  • Liquidity factor.
  • High-frequency traders as market-makers.
  • Hot potato volume effect.
  • Main conclusion.

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Liquidity factor

Most accurately the market liquidity is characterized by three indicators: size, price and time. When the market liquidity is high, investors and speculators may successfully open big orders close to the current prices during a short period of time. The Bid-Ask spread size is a popular indicator of liquidity.

According to the New York Stock Exchange (NYSE) brochure, “liquidity is the market depth capable of absorbing even big buy or sell orders at the prices that correspond with demand and supply. The market also should quickly adapt to the newly received information and take this information into account in the stock price”. Liquidity is an important characteristic of the efficient market which strengthens confidence in it among its participants.

The recent decade tendency shows that the use of HFT in the market significantly increased and its liquidity increased too. But the main question is: is there a cause-effect link in this correlation? Does HFT increase market liquidity at the same time reducing transaction expenses?

Before the changes, which introduced the concept of Alternative Trading Systems (ATS), were made approximately in 2000 in the system of the market regulation, the New York Stock Exchange already worked on the system of a two-sided auction, where matching of buyers and sellers was performed by traders and exchange specialists. The use of electronic trading systems gave birth to a new system – high-frequency securities trading. According to the majority of assessments, today HFT forms 50-75% of the whole trading volume of the stock market. Both small little-known and big investment banks and hedge funds are involved in high-frequency trading.

High-frequency traders as market-makers

Some strategies used by HFT definitely provide liquidity to the market. For example, HFT firms play the role of official or unofficial market-makers. As market-makers, HFT firms post limit orders simultaneously from both sides of the electronic book of limit orders, providing that way liquidity to the market participants. The majority of market-makers tend to make money on the Bid-Ask spread, buying on Bid and selling on Ask. If you want to learn what preferences the exchange provides the market-makers with in the queue of limit orders, read our Order matching algorithms. Part 2 article.

Since market-makers take the risk of losses from actions of a better informed counteragent, they need to renew the received data frequently in order to reflect the most urgent information. These constant changes take place depending on the prices of derivative financial instruments (such as ETF or futures) or posting or cancelling orders. Due to this, HFT market-makers perform a large number of transactions on posting and cancelling orders in response to a necessity of constant renewal. Their interest in making money on commissions from providing liquidity in the American stock market made many of them officially register as suppliers of liquidity while the others continue to perform the functions of unofficial market-makers. In this sense, HFT increases market liquidity and reduces trading expenses due to a narrow Bid-Ask spread.

Hot potato volume effect

Opponents of high-frequency trading believe that the liquidity, which is created by HFT, is superficial since securities are held by them for a rather short period of time (seconds or even milliseconds) before they are again resold to the market. Most of the time, securities are bought and sold with high frequency among high-frequency traders until they are bought by an investor. HFT opponents state that namely that is why no liquidity is created in the end and all this just facilitates the order execution.

HFT results in the so-called hot potato volume effect. Situations, when high-frequency traders resell each other and other market-makers the same assets several times, are not rare. Thus, a big volume without a respective depth is created. For the orders to be absorbed by the market, buyers should hold their positions during a longer period of time than several seconds.

Main conclusion

High-frequency trading became a comparatively acceptable element of the stock market for more than the ten-year history of its existence. There is a common opinion that, in general, HFT added liquidity to the market and reduced operating expenses. Due to the fact that HFT firms have already been introduced into the legal and regulatory framework, there is a big probability that any unethical behaviour from their side is detected and put down.

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