Vanderbilt study debunks “phantom liquidity” problem caused by high-frequency traders

Elise Fleischaker Industry News

hftContrary to popular belief, high-frequency traders help lower investor costs: @VanderbiltOwen study by Jesse A. Blocher the assistant professor of finance at Vanderbilt University’s Owen Graduate School of Management.

This is a very interesting study into the claims that HFT create “phantom liquidity” and harm the markets for the average investor as originally written in Michael Lewis’ book Flash Boys.  Some exerts:

Phantom liquidity only can really be a problem if those who cannot get good execution find the price moving against them when they try to trade,…

To determine the effects of HFTs cancellations, the researchers identified what they termed “cancel clusters,” brief periods that arise from HFTs cancelling multiple trade orders within a small timeframe. Their investigation yielded three main findings:

  • Cancel clusters are not a dominant feature of the trading day. The average cancel cluster lasts for just 5.68 seconds and they occupy 6.7 percent of the trading day.
  • The least common event taking place during a cancel cluster is that trade executions occur, suggesting that HFTs are not systematically luring investors into placing unwanted trades. In fact, the most common behavior after a cancel cluster is that the bid or ask prices revert to their pre-cancellation levels.
  • Most trading execution takes place outside of cancel clusters, and it is only once trade executions take place that stock prices move.

So why are HFTs engaged in this practice of placing, then cancelling, large batches of orders? Blocher and his colleagues argue that “cancel clusters are a lower-cost means of price discovery.” In other words, HFT computer algorithms run a kind of rapid series of tests to determine the “right” price of an asset, rather than use the method to try to trap (and profit from) unsuspecting investors.

Read the full article on Vanderbilt University web page.

or read the full study in the Journal of Trading.