Katya Malinova

Do Retail Traders Suffer from High Frequency Traders

In April 2012, the Canadian regulator IIROC imposed a fee on order submissions and cancellations. Worldwide, this was the first time that a regulator imposed a cost on activities that are intrinsic components of high frequency traders’ strategies. We find that high frequency market makers adjusted their behavior and acted significantly less competitively, so that market-wide bid-ask spreads rose by 9%, causing an increase in trading costs for retail traders. The implementation shortfall for institutions that used marketable orders increased, too, but for those that use both market and limit orders, costs remained unaffected. Our study provides causal evidence for the critical importance of liquidity provision by high frequency market makers in today’s markets.

Dark Trading on Public Exchanges

Over the last decade, market participants increasingly use trading tools that allow them to hide their trading intentions. We study how “dark trading” in the form of fully hidden, or dark, orders posted on a visible exchange affects the quality of the visible market. Dark orders were introduced on the Toronto Stock Exchange in 2011 in two stages, allowing us to employ a difference-in-differences approach to isolate the causal effect of the availability of dark trading. Using order-level data, we observe that the introduction of dark orders led to a widening of quoted spreads and an increase in trading costs, leaving depth, volume, and volatility unaffected. At the intra-day level, dark trading leads to decreased quoted spreads, increased depth, increased volume and to reduced trading costs and volatility. We interpret our findings as two sides of the same coin: the possible presence of dark liquidity causes market participants to post visible quotes more carefully. Upon detecting dark executions, however, traders infer that dark liquidity is diminished and thus post quotes more aggressively.

Regulating Dark Trading: Order Flow Segmentation and Market Quality

We examine the impact of a rule in the Canadian equities market that requires dark orders to offer price improvement over displayed orders. We show that this rule eliminated intermediation of retail orders in the dark and shifted retail orders onto the lit market with the lowest trading fee. Intermediaries shifted liquidity supply to this market leading to increased displayed liquidity. We conclude that reducing retail order segmentation enhances lit liquidity. Despite the improvement in liquidity, retail traders receive less price improvement; retail brokers pay higher trading fees to exchanges, and high frequency traders earn higher revenues from trading fees.

Taxing High Frequency Market Making: Who Pays the Bill?

In April 2012, the Canadian regulator IIROC imposed a fee on order submissions and cancellations. Worldwide, this was the first time that a regulator imposed a cost on activities that are intrinsic components of high frequency traders’ strategies. We find that high frequency market makers adjusted their behavior and acted significantly less competitively, so that market-wide bid-ask spreads rose by 9%, causing an increase in trading costs for retail traders. The implementation shortfall for institutions that used marketable orders increased, too, but for those that use both market and limit orders, costs remained unaffected. Our study provides causal evidence for the critical importance of liquidity provision by high frequency market makers in today’s markets.

Market Design with Blockchain Technology

Blockchain or, more generally, distributed ledger technology allows to create a decentralized digital ledger of transactions and to share it among a network of computers. In this paper, we argue that the implementation of this technology in financial markets offers investors new options for managing the degree of transparency of their holdings and their trading intentions. We first identify two intrinsic features of a distributed ledger that impact the availability of these new options, namely the mapping between identifiers and end-investors and the degree of transparency of the ledger, and we then examine how the implementation design of these critical features affects investor trading behavior, trading costs, and investor welfare, in a theoretical model of intermediated and peer-to-peer trading. We find that, despite the risk of front-running, the most transparent setting yields the highest investor welfare. In the absence of full transparency, for low levels of liquidity in the intermediated market, welfare is highest if investors are required to concentrate their holdings under single identifiers.