Menkveld, Speed, Spy vs. Spy, and Deteriorating Market Quality



Albert Menkveld is a professor at VU University Amsterdam who is known for studying the infrastructure of our global financial markets, especially pertaining to the effects of automation. Menkveld, after gaining a degree initially in econometrics, started his career working at the Dutch airline, KLM, writing algorithms to optimize ticket prices.

Recently he has written quite a few academic papers (with other academicians) studying high speed / algorithmic trading. These include 2011’s Does Algorithmic Trading Improve Liquidity, 2013’s High Frequency Trading and The New-Market Makers, and the current revised Need for Speed? Exchange Latency and Market Quality. As Bloomberg writes in Exchanges Can Ruin High-Frequency Trading Benefits:

“You’ve got these two types of high-frequency trading firms dueling, and if you speed up the market, it is more of a game between these two players and less of a game between them and investors,” Menkveld said during a phone interview. “In this game, those putting out quotes are more prone to making losses. This is compensated for by them making wider spreads, which means end investors pay higher spreads.”


Menkveld studied the effects on market quality (bid-ask spreads primarily) before and after a February 2010 NASDAQ speed upgrade to its equity exchanges of Copenhagen, Helsinki, and Stockholm. The round-trip latency dropped from 2.5 milliseconds to 250 microseconds.

Ironically, the SEC itself in March 2014 cites an earlier paper of Menkveld’s to demonstrate that the introduction of HFT to markets results in lower bid ask spreads and lower transaction costs. And yet this updated May 2014 shows that high speeds enabled by stock exchanges (in this case NASDAQ OMX) are serving to actually increase those same spreads and transaction costs. Menkveld is arguing that the markets have become so fast that the latest latency reductions are pitting HFTs against each other more and more. High Frequency Market Makers (HFMs) are being picked off by even faster High Frequency Bandits (HFBs).

Can both be true? Can one type of HFT be good for the markets, while other types deteriorate market quality? How do we identify HFMs versus HFBs? Can the same firm be engaging as HFMs and HFBs? How can regulators tell? It is important to note here that Menkveld’s study uses user-level data from NASDAQ OMX, whereas the SEC’s often heralded MIDAS data has no such detail.

Some excerpts from Menkveld’s latest updated study:

1)      The paper’s main result is that reducing exchange latency (i.e., increasing speed) deteriorates market quality. Trading becomes more of a zero-sum game between high frequency traders as (by assumption) they are the only ones whose clock speed can match the speed of the exchange. High frequency market makers have to set a wider spread to recoup the increased adverse selection cost due to more often meeting high frequency ‘bandits’.

2)      Faster markets imply more quote flickering.

3)      Beyond a threshold speed HFMs start paying a monitoring cost to protect themselves against HFBs.

This paper shows that stock exchanges like NASDAQ OMX are doing the markets as a whole a disservice by increasing the speed of their platforms. While increasing the speed may serve to increase the value of the exchanges’ colocation services, and the exchanges’ profitability, it is harming the marketplace as a whole.

Menkveld’s finding can be expected to help continue the speed debate in our modern markets, especially in the wake of Michael Lewis’s Flash Boys. We have written extensively over the years that the arms race perpetuated by the stock exchanges has benefitted precious few at the expense of many. We have argued that the costs can not solely be captured by looking at bid-ask spreads. We all pay the cost for increased technology infrastructure, increased compliance costs resulting from having to police our orders with increasing granularity, and the increased education costs of trying to continually keep up in a socially meaningless game of Spy vs. Spy.

Add all of those costs up, and add them to the increasing bid-ask spreads now being documented. It is it any wonder IEX is taking off? Is it any wonder IEX’s methodology of actually slowing down the game is gaining traction?

Perhaps the traditional stock exchanges, as well as the SEC’s Gregg Berman, may want to have another look at their preconceived notions about the positive role speed is playing in modern markets.