Limit Order Placement By High-Frequency Traders
University of California, Los Angeles (UCLA) – Finance Area; Centre for International Finance and Regulation (CIFR)
Discipline of Finance, The University of Sydney; Capital Markets CRC Limited
November 10, 2015
Using a unique dataset consisting of limit order placement, execution, and cancellations on Nasdaq, we examine liquidity provision by high-frequency trading (HFT) firms, which is a central issue in the ongoing debates about HFT. We find that HFT firms more effectively use order cancellation to strategically manage their limit orders in anticipation of short-term price movements than non-HFT firms. HFT firms increase their liquidity provision during periods of high volatility; their liquidity provision is less affected by order imbalance shocks than that of non-HFT firms. Overall, our results indicate that HFT limit orders exert a stabilizing influence on markets.
Limit Order Placement By High-Frequency Traders – Introduction
The significant growth in high-frequency trading (HFT) in recent years has led to considerable debate about its impact on market quality and wealth distribution among investors.1 A key question is whether HFT improves market liquidity (Jones 2013). Researchers generally report that HFT improves market quality by narrowing bid-ask spreads (Jovanovic and Menkveld 2011; Malinova, Park, and Riordan 2013) and supplying liquidity in transactions when spreads are wide (Carrion, 2013). Others argue that the liquidity provided by HFT is illusory and difficult to access because it is usually cancelled within an exceptionally short period of time (i.e., in milliseconds), and has been dubbed as “phantom liquidity.”2 Some researchers have focused on the liquidity-taking behavior of HFT firms, with some limited analysis on their liquidity provision during transactions (Brogaard, Hendershott, and Riordan 2014), yet few have examined the interaction between HFT liquidity providers and the limit order book (LOB) to directly address the concerns raised by the opponents of HFT.3 An understanding about the liquidity provided by HFT firms (hereafter, HFT liquidity) via the LOB can potentially contribute much to the ongoing debate about the role played by HFT firms in modern securities markets.
Chordia, Roll, and Subrahmanyam (2000, 2001) and Acharya and Pedersen (2005) demonstrate the importance of market liquidity. In today’s securities markets, HFT firms have largely assumed the role of traditional human market makers (Menkveld 2013), so that it is especially interesting to understand how they provide liquidity via limit orders. We note that limit orders are an important source of market liquidity (Biais et al. 1995), and recent advances in trading technology have significantly reduced the costs to monitor and alter limit orders (Hasbrouck and Saar 2011; Jones 2013), making limit order trading more attractive. Jovanovic and Menkveld (2011) and Hoffman (2014) suggest that compared with non-HFT firms, HFT firms are more likely to supply liquidity via limit orders since their superior technology can reduce adverse selection risk in market making.5 Finally, the widely-adopted maker-taker pricing by exchanges around the world provide additional incentives for traders to trade via limit orders.
In this study, we examine how HFT firms provide liquidity on the limit order book (LOB). We reconstruct the LOBs for a sample of 116 stocks traded on Nasdaq during the first quarter of 2011. Using information on 26 trading firms which are identified by Nasdaq as mainly engaging in HFT activities, we provide a detailed analysis on their liquidity provision activities via limit order placement, including executed and cancelled orders. To the best of our knowledge, such an analysis of HFT limit orders has not been conducted before.6
We find that the average size of HFT limit orders is smaller than that of the limit orders from other traders, whom we define as the non-HFT firms. However, the median sizes of limit orders are similar between groups. The limit order cancellation ratios are also very similar between HFT firms and non-HFT firms. The limit order execution ratios are smaller for HFT firms when we examine limit orders submitted to the top three price levels of the LOB. However, when we include all limit orders submitted to the top 50 price levels of the LOB, the order execution ratios become similar between the two groups. In general, our results show that the commonly perceived special features of HFT liquidity provision, such as smaller order size and being less accessible when needed by liquidity demanders, are not unique to HFT liquidity.
A large number of limit orders submitted and cancelled within a short period of time can increase the uncertainty of liquidity and affect wealth distribution among traders.7 The rise of such fleeting orders is widely attributed to the increase of HFT, but there is little evidence to support this perception. We analyze this issue and find that the time that a limit order rests on the LOB is significantly shorter for the limit orders of HFT firms than for those of non-HFT firms. For stocks with large, medium, and small market capitalizations (hereafter, large-, medium-, and small-cap stocks), the median time a limit order rests at the top 50 price levels of the LOB before an execution or cancellation is 1.85, 6.02, and 18.30 seconds for HFT firms, and 4.12, 8.98, and 22.43 seconds for non-HFT firms, respectively. For limit orders submitted to the top three price levels of the LOB, the median time to cancellation of HFT firm (non-HFT firm) limit orders is 0.53 (3.02), 2.15 (3.47), and 6.84 (4.48) seconds for large-, medium-, and small-cap stocks, respectively. These results confirm the common belief that HFT liquidity rests on the LOB for a shorter period of time than non-HFT liquidity.
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