Researcher: Dark Trading Bad, HFT Good
June 5, 2012
An Australlian research center says moving trades into dark pools in small markets increases trading costs on lit markets by three times the round-trip exchange fee. But high-frequency trading increases liquidity in futures markets.
According to a model constructed by the Capital Markets Co-Operative Research Centre in Sydney, trading costs on lit exchanges increase by almost 1 basis point, when 20% of all trading moves into the dark. That is three times the typical round-trip exchange fee of 0.3 basis points.
Designed for the Australian market, it is also applicable to other small markets with fast trading technology, such as Canada and Singapore.
“When trading moves off-exchange, trading costs on the lit exchange rise because markets fragment and this makes it more costly for buyers and sellers to find it each other” said Professor Alex Frino, CEO of Capital Markets Co-operative Research Centre (CMCRC) and Professor of Finance at the University of Sydney Business School. “This implies that dark liquidity has a significant negative impact on liquidity, and for price discovery.”
Frino will present his research this week at a presentation in the Distinguished Speaker Series at the Australian Embassy in Washington DC.
Professor Frino pointed out that his research was particularly focused on smaller markets. “In big, liquid markets like the US, or even Japan, moving some trading off-exchange really makes no difference,” he said. “There, where the top five stocks on Nasdaq trade five times the volume of the whole Australian market every day, taking a portion of that trading activity away isn’t that meaningful for trading costs and volumes. But in Australia or Singapore it’s a very different story because volumes and liquidity are low to begin with.”
The problem in smaller markets is that they’re “fragmenting” just like bigger markets have, Frino says.
“We’re seeing markets fragment in Asia as we did years ago in the US and Europe,” he said. “The issue is that some Asian markets aren’t big enough to handle it. Pulling liquidity off the lit exchanges, and the subsequent increase in trading costs, only further injures already struggling volumes.”
The Capital Markets Cooperative Research Centre also has found that high-frequency trading “provides positive benefits for the structure and liquidity of futures markets.”
The center applied models developed in 2011 for equities markets, to futures markets. These models examine the impact of HFT on liquidity provision and volatility.
Co-location of trading firms’ servers under the same roofs as market centers’ matching engines increases greatly the amount of HFT activity, and in turn this enhances market liquidity, Frino said
Professor Frino’s models look specifically at liquidity from ‘make’ and ‘take’ perspectives – how often a quote is hit, and how often HFTs hit existing quotes. The team found that HFTs are overall net providers of liquidity, and that their liquidity is used as readily by other market participants as any other type of liquidity.
“HFTs appear to assist in decreasing excessive price volatility,” Frino said. “This is partly due to the way HFT algorithms identify trading opportunities – they’re built to recognise when prices are abnormally high or low, and respond in a way that naturally pushes prices back towards the middle.”