High Frequency Trading and the Evolution of Liquidity in US Equity Markets

What regulatory changes make sense?

Any regulatory intervention must be handled very carefully: messing around with anything approaching 70% of the overall liquidity risks killing the goose. That said, high frequency trading has recently spawned the concept of flash orders, which deploy temporary, private quotes for small, non-block, non-discretionary orders. Most of these orders would – in the absence of the “flash” function – take part in the normal price discovery process.

While some regulatory action regarding flash orders may be needed to maintain the integrity of our price discovery process, the size discovery process must be dealt with separately. Investors cannot have their block-sized, discretionary orders displayed to the trading community-at-large. They need the flexibility to quietly signal others who are likely to trade in size, and unlikely to create market impact.

In a certain sense, high frequency trading is a competitive response to unmet needs in the marketplace, and the resulting liquidity has become essential to the market – the trick is to understand how investors can trade in the current environment, but avoid paying too much for the liquidity they need.

How can institutional traders stay on top of the evolving landscape of liquidity provision?

A trader’s approach to minimizing trading losses is today very different from the tactics employed a decade ago. Years ago, traders would put an overly aggressive dealer “in the penalty box” by withholding order flow. More recently, traders would attempt to disentangle their orders from abusive fills by disabling suspect dark pools.

Today, traders need to control execution timing to limit losses caused by adverse selection. When significant liquidity is demanded, it is not proving helpful to totally eliminate any of the active dark pools. Instead, dangerous ones need to be treated with respect, but tapped at the appropriate moments to realize the liquidity institutional traders need.

With the mix of trading strategies active in the equity market ecosystem now, high frequency traders are providing much of the liquidity, but also delivering real trading losses to the average institution. Some institutions will do better than average – collecting the liquidity they require while incurring smaller losses to liquidity providers – and some will suffer larger losses, effectively funding more than their share of the liquidity-provisioning process. Exceptional traders can harvest that high frequency liquidity, while limiting adverse selection losses through sophisticated control of trade timing, and limit their impact losses through obfuscation of trading interests. An ongoing focus on state-of-the-art techniques for limiting adverse selection losses and direct market impact losses will put institutional traders, and the millions of individual savers they represent, back in the driver’s seat.

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