High frequency trading (HFT) firms are commonly thought of as the new market makers although, unlike traditional dealers, they have no affirmative obligation to create fair and orderly markets. We investigate the quality of HFT provided liquidity by focusing on whether HFT firms create, with reasonable consistency, two-sided markets. We us Sarkar and Schwartz’s (2009) sidedness metric to quantify the contributions of both HFT and non-HFT firms to liquidity. In so doing, we pay attention to liquidity provision by the HFTs during relatively normal periods versus more stressful, challenging periods.
Data/Methods
We use the intra-day data of all trades and quotes for 120 stocks, out of which 40 are large-cap, 40 are mid-cap, and 40 are small-cap stocks. The data, obtained from NASDAQ, identify whether each trade and quote comes from an HFT firm or from a non-HFT firm, whether the HFT/non-HFT was the side providing liquidity, and whether it was a buyer or seller initiated trade. Our study period includes the calendar years 2008 and 2009.
Results
Regarding magnitude, we find, for large-cap stocks, that the liquidity provided by HFT trading is slightly less than that provided by non-HFT trading (46% versus 54% respectively), and that HFT liquidity provision is markedly lower for mid-cap stocks (21% versus 79%, respectively). Sidedness, however, is a different story. For both large cap and more volatile stocks, HFT liquidity provision is predominantly two-sided, even during very short (one-minute) measurement intervals, and it increases as the measurement interval is lengthened. In contrast, non-HFT trading during one-minute intervals is one-sided for all cap sizes and all volatility levels. Hence, while our findings with regard to the aggregate level of liquidity provision are more positive for the non-HFT traders, the quality of sidedness provision favors the HFT firms.
For the large caps, HFTs continue to provide two-sided liquidity at the more challenging times of the trading day, namely, the opening and the closing half-hour periods, albeit both the level and the significance of their two-sidedness is lower compared to what we observe for the entire trading day. Moreover, for mini-flash crashes that take place within seconds, liquidity provision by HFTs drops precipitously, particularly for large cap stocks. Thus, while there is merit to characterizing HFTs as the “new market makers”, they appear to be selective in terms of the conditions under which they contribute to markets.