Singing in the Rain!
This is awesome. There is no other way to describe this academic study, which will make you (as investors) sing, dance, and rejoice when it rains.
For a decade we have argued that with regard to speed, our modern markets have “jumped the shark.” While proponents of Modern Markets have argued that speed has improved liquidity and tightened spreads, we have argued the opposite. First, spreads have not meaningfully narrowed in a decade, and in fact have widened some. Second, there is a big difference between liquidity and volume.
Anywho… researchers from Canada’s Wilfrid Laurier University, drawing on some assistance from Notre Dame’s Robert Battalio, Babson’s Michael Goldstein, and the SEC’s Austin Gerig, have focused on an interesting way to test the theory that more speed improves markets and liquidity: Andriy Shkilko and Konstantin Sokolov look at what happens to markets when microwave networks, and the speed advantages they bestow on high speed collocated traders, are disrupted by weather!
In their paper, Every Cloud Has a Silver Lining: Fast Trading, Microwave Connectivity and Trading Costs, they analyze and discover how, when the microwaves are impaired by weather, adverse selection declines, liquidity improves, and volatility is reduced.
Specifically, they study markets when it rains or snows, which impairs microwave networks, and forces high speed traders to fall back on their slower fiber-optic networks (think Spread Networks, tunnels, and Michael Lewis Flash Boys). They additionally note that there was a specific point in time beginning in 2013 when access to microwave data was democratized some, and use this point in time as a pivot to study fast trader behavior.
Our data show that when microwave technology allows these arbitrageurs to speed up, both price impacts and trading costs increase. This result may appear counterintuitive to some readers because arbitrageurs are often viewed as liquidity providers who enhance market efficiency.
Our analysis is based on millisecond DTAQ data. The sample period spans four years, from January 2011 through December 2014. The first two years (2011-2012) are characterised by the proliferation of microwave technology. The latter period (2013-2014) captures the time after the technology was democratized.
The authors collect weather data from NOAA collected along 83 weather stations along the Chicago – New York corridor. They note that substantial rain in any one station/area (i.e. Ohio) will disrupt the microwave network transmission.
They find the following:
- Price impacts to stocks decline during network disruptions.
- A loss of speed reduces adverse selection as a whole.
- Trading Costs decline.
They also note that beginning in early 2013, microwave transmission was democratized by one provider who sold access to anyone for nominal fees (as opposed to pre 2013 – when only the fastest traders accessed these networks). The authors hypothesized that taking away the speed advantage from the fastest high speed traders would mean that the “rain -market quality relationship” they found earlier in their study would be diminished. And data backs up their hypothesis!
In a nutshell, what Shkilko and Sokolov have accomplished in this work is test the effects of speed differentials on liquidity. Their work shows that technological arms races, like the ones the major exchanges do desperately try to sell, leads to markets with speed differentials and suboptimal market quality.
This study is food for thought, as we watch the UK Vigilant structure being constructed, and we watch high speed traders switch to USING LASERS in the USA.
Please feel free to download their paper at the link provided above. And know that you will not see Modern Markets and other high speed lobbyists in Washington pushing and publicizing this important study.