As critics have charged, high-frequency traders do appear likely to withdraw liquidity when market volatility increases, according to a new paper from the U.S. Federal Reserve Board.
The Fed issued a staff working paper Monday that looks at the issue of high-frequency trading (HFT) and the impact of information asymmetries that can arise due to differences in speed between HFTs in processing incoming market data. The paper argues that when liquidity-taking HFTs enjoy a speed advantage in the processing of certain information, such as the prices of index futures or ETFs, an information asymmetry arises that is meaningful to markets.
The paper uses the example of the price of the Nasdaq-100 ETF to show that the information asymmetry problem exists and that the market-making HFTs supply less liquidity to stocks that are more prone to this problem. “My results also indicate that stocks with low spreads, high beta, and low volatility have a greater information asymmetry,” says report author Yesol Huh, adding, “Moreover, when markets are volatile, this information asymmetry problem becomes more severe, and HFTs supply less liquidity.”
Indeed, one of the major criticisms about the rise of HFTs is that since they do not have market making obligations, they might leave the market when volatility increases, despite the fact that this is when market makers are needed most.
The paper says that the significance of this information asymmetry should also be considered when considering potential HFT regulations. For example, it notes that regulators have proposed imposing a minimum quote duration to prevent HFTs from overloading exchanges by submitting and canceling a large number of orders.
“Adopting this proposal might have an unintended consequence of increasing information asymmetry, as it would disadvantage the liquidity-providing HFTs’ ability to quickly adjust their quotes for hard information without handicapping the aggressive HFTs,” it says.
“If the sole purpose of the proposal is to limit the amount of data flooding caused by HFTs, other measures such as imposing a fine for a low executions-to-orders ratio might be a better idea,” it suggests.