More Academic Evidence That High Quote Rates Hurt Market Quality


Data….regulators want data before they make any decisions on market structure problems.  Even though most academics and market participants do not have access to full sets of data, our regulators still are demanding it and really don’t seem to care about “anecdotal” evidence.  While, we at Themis Trading are not academics, we try to do our part by highlighting the many academic studies that we find that do crunch the numbers.  We’d like to once again point our regulators to the RT Leuchtkafer bibliography of academic studies that we have highlighted numerous times in our notes.  RTL did a tremendous job of summarizing numerous evidence based research papers as well as other literature which highlights many market structure problems.

Today, we’d like to add a new academic paper to the list that raises some serious questions about the effect of high intensity quoting on market quality.  The paper is titled  ”Quote Intensity and Market Quality: Effects of the SEC Naked Access Ban” and was written by four academics.

The study is the first that we have seen which isolates the effect that SEC’s Naked Access ban  (which took effect in November 2011) had on market quality.

Just to refresh your memory, back when the Naked Access ban was approved in November 2010, SEC Chair Mary Schapiro had this to say:

I have previously likened unfiltered access to giving your car keys to a friend who doesn’t have a license and letting him drive unaccompanied,” said SEC Chairman Mary L. Schapiro. “This rule requires that broker-dealers not only remain in the car, but also maintain control of it so we can all be assured the rules of the road will be observed before the car is ever put into drive.”

While most of us on the institutional side of the business were not affected by this rule, many high frequency sponsored access clients of some broker/dealers were affected.  The authors of the paper explained the issues surrounding naked sponsored access:

After several years of spectacular growth, high-speed trading in the U.S. appears to have hit a speed bump in the form of the SEC 2011 ban on naked access. Prior to the ban, broker- dealers and market makers allowed their clients, a number of whom were HFT firms, to directly route orders to exchanges using the broker’s MPID. By by-passing order compliance and pre-trade capital checks, such arrangements, known as direct market access or sponsored access, allowed the client firms to reduce order routing and execution times, i.e., reap latency gains, which is one dimension along which trading firms compete. The lack of pre/during/post trade supervision under naked access created compliance and possibly systemic risks.”

The authors were able to obtain data from the TAQ database and used the ban on naked sponsored access date as their control date.  They were able to observe quoting activity, spreads and trading costs before and after the ban and found some remarkable results.

Are the critics correct in their negative view of modern order/quote submission intensities? Using the naked ban as an instrument, we show that market quality improved after the ban. Specifically, quoted spreads fell by 12.5%, and quoted depths increased by 41%. This decline in quoting and trading activity was accompanied by a reduction in trading costs, with effective spreads down by 9.6%.”

“Using the ban as an exogenous instrument in a 2SLS setting, we show that a 1% reduction in the trade-to-quote ratio – our measure of quoting intensity – leads to a 0.40% reduction in quoted spreads, a 0.44% increase in quoted depths, and a 0.20% decrease in effective spreads. Overall, our results conform to the claims that some modern order submission practices do not benefit market quality.”

Folks, this is not anecdotal evidence.  This is evidence based on data that proves excessive quoting and cancellations hurt market quality.  We’ll make sure we forward this paper to our friend RTL and ask him to include it in his growing bibliography.