Guest Post: Major Structural Changes in US Equity Markets You Must Know
Brandon Rowley over at Wall Street Cheat Sheet has penned a post conveniently summarizing some of the most critical market structure trends that we have been highlighting for the past year. In a market that is increasingly computerized, the only key benefit presented by the pro-algo lobby has been that liquidity has increased. And while that may indeed be the case for the 50 or so most traded stocks whose trading is dominated by HFTs, the trade offs have been a spike in the average quotes per minute over the past decade, a fake order depth which disappears on a moment's notice, a dramatic shift away from traditional marketplaces and to "gray" venues, and most importantly, a massive surge in the cancellation to execution ratio, which is currently at an all time high, with the Nasdaq seeing 30 cancels for every execution. With so much probing and poking by computers to test which bids and offers are real, it is a miracle we don't have flash crashes every single day, as the bulk of the liquidity, likely well over 90%, is a sham.
Guest Post Submitted by Brandon Rowley of Wall Street Cheat Sheet
Major Structural Changes in US Equity Markets You Must Know
Knight Capital Group recently commissioned a study entitled “Equity Trading in the 21st Century” that explores
the major structural changes we have seen in the markets so far this
century and the impacts it has had on investors and traders. I will not
offer an opinion or recommendation but rather just summarize the
transformations the authors present.
The professors who authored the paper offer well-argued perspectives
and it’s worth the read if you are interested in the regulatory angle.
But, based on previous interest in our articles on high frequency
trading, it seems that many would find it worthwhile to examine the
changes that have fostered a system where HFT dominates the tape for
better or worse. So, how has the market changed?
Displayed Depth Has Increased
Within six cents of the national best bid and offer, the depth of the
book has seen a dramatic increase recently. From 2003-2009 the depth
looks to have averaged around 2,000 shares on the bid and offer for
S&P 500 companies. Yet, in just 2009, the book saw a dramatic jump
in displayed quote volume leaping from lows of 1,500 shares to over
4,500, a 200% increase.
The depth, to be sure, is not necessarily indicative of actual
executed volume. We argued in an earlier
paper that this is largely a result of HFTs providing bids and
offers that they intend to cancel without a fill such that the “real”
depth is much less than displayed. Note: the inclusion of stocks outside
the S&P 500 based on nominal share sizes is misleading. We would
rather see these stocks on their own graphs or a logarithmic graph to
interpret it logically.
Average NYSE Trade Size Has Consistently Fallen
Average trade size on the New York Stock Exchange (NYSE: NYX) has
consistently fallen for the last six years. At the beginning of 2004
average trade size was over 700 shares while now it is slightly over 300
shares. The hyper growth in automated trading strategies has helped cut
average trade size in half in five years. Large-scale investors have
utilized algorithms to execute orders in an effort to hide their
intentions and reduce price impact.
Splitting up large orders into smaller and smaller pieces minimizes
the impact of any single order on the market and can reduce other
traders’ abilities to capitalize on their inefficient order flow. Many
scalp-style active traders have found order flow more and more difficult
to read because falling transaction costs have allowed institutions to
invest heavily in algorithm development in order to hide their
intentions while executing orders.
Average Quotes per Minute Skyrocket, Then Return to Earth
Average quotes per minute coming through skyrocketed in the Panic of
2008 when markets became the most volatile they had been in decades.
Quotes per minute went from below 50 to over 500 in five years before
falling back to more normalized levels as volatility slowed. Quotes per
minute are now around 200, still roughly a 900% increase in the last six
Cancels to Executed Steadily Rising
Early 2002 saw a cancellation to execution ratio of ten to one, but
that ratio has steadily climbed over the years. Now, the Nasdaq sees 30
cancels for every execution according to Knight Capital Group’s
research. This increasing ratio and the upsurge in average quotes per
minute is consistent with a market that has become HFT dominated with
greater total volumes coupled with lower average trade sizes.
NYSE to Become a Museum
Volume on the New York Stock Exchange has collapsed and it seems like
it won’t be much more than a decade from now that the NYSE Floor will
be turned into a museum. Regulation National Market System (NMS) was
passed in 2005 and opened the NYSE up to increased competition. At the
beginning of 2003, the NYSE executed 80% of the total volume.
This ratio has plummeted as electronic communication networks (ECNs)
gobbled up market share.The NYSE ex
ARCA accounted for only 25% of all volume by the end of 2009, about a
70% decline in market share in just five years. NYSE Euronext has wisely
invested in ARCA so the company is far from doomed, but the physical
floor will likely be an exhibit in the not too distant future.
All these charts are consistent with the growth in high frequency
trading as a means of increasing efficiency, making the execution side
of the business largely computer-driven. The days of the floor broker
are rapidly disappearing. Automated trading is here to stay and
participants need to learn
how to adapt.
All charts are excerpted from “Equity Trading in the 21st Century” commissioned by
Capital Group and authored by professors James Angel of Georgetown
University, Larry Harris of the University of Southern California, and
Chester Spatt of Carnegie Mellon University published on February 23,
2010. Brandon Rowley is a professional trader at T3 Live.