Who Really Supplies Liquidity?


A new paper just published by the Bank for International Settlements has the HFT community applauding and cheering from the tops of their microwave antennas.  The paper, titled “Who Supplies Liquidity, How and When?”, suggests that high frequency traders supply liquidity even in volatile markets.  HFT proponents have been waving this paper around for the past few days as proof that they are actually liquidity providers and not just high-speed, predatory traders who use their latency advantage to pick off less sophisticated and predictable algorithms.

Before we get into the findings of the paper, it’s always important to check which dataset was being studied.  This paper used data from 2010 on French stocks that were traded on Euronext. The dataset was high quality but it was so large that the authors could only study 23 French stocks (10 large caps, 9 mid-caps and 4 small caps).

Now let’s take a look at some of the findings of the paper.  Here are some of the main points of the paper with our comments underneath:

  • “Who provides liquidity in modern, electronic limit order book, markets? We find that proprietary traders, be they fast or slow, provide liquidity with contrarian marketable orders, thus helping the market absorb shocks, even during a crisis, and they earn profits while doing so. Moreover, fast traders provide liquidity by leaving limit orders in the book.”

Themis comment:  This finding seems to differ from the Joint CFTC/SEC Flash Crash Report which said that during the May 6th Flash Crash, many high frequency traders engaged in “hot-potato” trading before eventually pulling out of the market altogether.  The Joint CFTC/SEC report stated:  “To protect against trading on erroneous data, firms implement automated stops that are triggered when the data received appears questionable.”  Essentially they are saying that, when the data was questionable, HFT liquidity disappeared

  • “In fragmented markets, intermediation services can be provided by those agents with the best network linkages and the greatest search ability, which can be enhanced by high-frequency trading technology.”

Themis comment:  We don’t necessarily disagree with this statement but we think the conclusion misses the bigger picture. Rather than praising HFT’s for gluing back together a fragmented maze of liquidity, we think the bigger question is how can we de-fragment the market which would make this HFT venue arbitrage unnecessary and would remove an unnecessary intermediary from the capital allocation process.

  • “Efficiency suggests that the intermediaries should be the agents who are best able to mitigate adverse selection. Such ability could reflect better market-monitoring technology, enabling intermediaries to cancel their orders before they are picked off. This, however, could worsen the adverse selection problem for other investors, with less efficient monitoring technologies. Adverse selection for these investors could be further amplified if intermediaries took advantage of their timely market information to hit stale quotes themselves.

Themis comment:  For some reason, the pro-HFT crowd forgot to highlight this comment from the paper.  The authors are saying that HFT’s use their superior technology to cancel their orders so they can avoid adverse selection.  And not only will they cancel their “liquidity providing” orders but they may even use their latency advantage to run ahead and hit stale quotes. And how again is this providing liquidity?

  • Our findings suggest that fast proprietary traders rely on numerous cancellations and updates to reduce the adverse selection cost incurred by their limit orders. Capping the percentage of cancellations and updates could increase the adverse selection costs incurred by limit orders left in the book, and thus deter the provision of liquidity by these orders. New banking regulations, making it more difficult and costly for banks to engage in proprietary trading, might also reduce market liquidity.”

Themis comment: The authors seem to be using the findings from their study to lobby against new rules which are set to be invoked under MIFID 2 that aim to  cut down the number of cancellations. They seem to think that HFT liquidity might diminish if cancellations were limited.  We don’t think that canceling orders over 99% of the time should be referred to as liquidity provision.

Once again, we have found another academic paper which tries to promote HFT as beneficial participants who are doing the market a service.  But once you read through the paper you can see that the authors fail to support this theory and actually end up supporting the case that HFT could be harming long term investors.