We read a lot of academic papers but seem to have missed this one from last April titled “High Frequency Trading and Market Stability”   written by Dion Bongaerts and Mark Van Achter from the Rotterdam School of Management, Erasmus University in the Netherlands.  The reason why we caught this paper now is because it was just awarded the Joseph de la Vega Prize 2015 for an outstanding research paper related to the securities markets in Europe.  The paper tackles the increasingly popular subject of the how high frequency trading affects liquidity .  We thought it would be worthwhile to take a closer look at this award winning paper especially considering the increased concern amongst regulators and policy makers about the lack of liquidity in today’s markets.
To study liquidity provision, the authors of the paper constructed a model which sought to isolate speed and information advantages.  They found “that in the absence or with low levels of informed trading, HFTs can improve liquidity and price discovery. More and faster HFTs reduce average transaction costs, and cause quotes to converge faster to the efficient price.”

 If you were reading a pro-HFT blog, the post would stop right there.  But you are reading a Themis Trading piece and you know we dig much deeper and present all the facts. The authors continued by saying:

“However, a different storyline unfolds when suspicions of informed trading are high. In such situations, HFTs will shun the market, even when these suspicions are ex-post unfounded/incorrect (e.g. if they were induced by a fat-finger error triggering a series of market orders). In those scenarios, only the LFTs can keep the market going. If, however, LFTs have been largely pushed out of the market as described above, trading will be thin, liquidity will be low, price discovery will be slow and markets can even stop functioning altogether.”

The authors are describing the evaporation of liquidity when volatility spikes.  In times of stress, when liquidity is needed most to act as a shock absorber, the authors are saying that HFT’s are nowhere to be found.  They go on to say:

“As such, our model captures the potential systemic risk HFT activity brings to financial markets. While an increase in HFTs’ market share improves liquidity and price discovery under some market conditions, it induces market freezes to arise in equilibrium with increasing frequency under other conditions.”

Yesterday, the House Financial Services Committee questioned Treasury Secretary Jack Lew about the liquidity event that hit the bond market on October 15, 2014.  While some members of Congress tried to blame Dodd-Frank and other regulations for the market’s liquidity woes, Secretary Lew seemed to indicate that he thought market structure and electronic trading also played a part.  Secretary Lew said his office was still studying that event but promised that they would be issuing a report “in a few weeks.”  We would like to recommend that Secretary Lew study this award winning academic paper before he issues his report.