electronic markets and high frequency

trading: same wine in new jars?

albert j menkveld
tinbergen institute, vu university amsterdam

december 2010

the nyse in 1873

the nyse today

literature
algorithmic trading: Foucault and Menkveld (2008), Hendershott,
Jones, and Menkveld (2010), Chaboud, Chiquoine, Hjalmarsson, and Vega
(2009), Hendershott and Riordan (2009), Biais and Weill (2010)

high frequency trading: Brogaard (2010), Kirilenko, Kyle, Samadi, and

Tuzun (2010), Jovanovic and Menkveld (2010), Menkveld (2010)

limit order books and information asymmetry: Foucault (1999),

Rosu (2006), Hollifield, Miller, Sands, and Slive (2006), Goettler, Parlour,
and Rajan (2009)

middlemen in search markets: Rubinstein and Wolinsky (1987),

Masters (2007), Li (1996), Duffie, Garleanu,

and Pedersen (2005), Lagos,
Rocheteau, and Weill (2009), Duffie, Malamud, and Manso (2009)

questions

1. does algorithmic trading improve liquidity?

Hendershott, Jones, and Menkveld (2010)
2. high-frequency traders as middlemen
Jovanovic and Menkveld (2010)
3. high-frequency trading and market structure
Foucault and Menkveld (2008), Menkveld (2010)

questions

1. does algorithmic trading improve liquidity?

Hendershott, Jones, and Menkveld (2010)
2. high-frequency traders as middlemen
Jovanovic and Menkveld (2010)
3. high-frequency trading and market structure
Foucault and Menkveld (2008), Menkveld (2010)

questions

1. does algorithmic trading improve liquidity?

Hendershott, Jones, and Menkveld (2010)
2. high-frequency traders as middlemen
Jovanovic and Menkveld (2010)
3. high-frequency trading and market structure
Foucault and Menkveld (2008), Menkveld (2010)

questions

1. does algorithmic trading improve liquidity?

Hendershott, Jones, and Menkveld (2010)
2. high-frequency traders as middlemen
Jovanovic and Menkveld (2010)
3. high-frequency trading and market structure
Foucault and Menkveld (2008), Menkveld (2010)

1. does algorithmic trading improve liquidity?

Hendershott, Jones, and Menkveld (2010)

timeSpreads
trend bid-ask
spread
for the
long

run

relative bid-ask spread

Dow Jones stocks
Figure 1. Bid-ask spreads on Dow Jones stocks
(all
DJ
stocks
1900-1928,
DJIA 1929-2000)
stocks 1929-present)
(all stocks 1900-1928, DJIA
stocks
1.60%
1.40%

Proportional spread

1.20%
1.00%
0.80%
0.60%
0.40%
0.20%
0.00%
1900

1910

1920

1930

1940

1950

10

1960

1970

1980

1990

2000

!"#$%"%&'()*+%'((,%"-%+*&*#-%./)-(+0
time
trend bid-ask spread (ctd)
nyse
value-weighted
average
effective
spread
Figure
1. NYSE
value-weighted
proportional
effective
spreads
0.25%

Proportional effective spread

0.20%

0.15%

0.10%

0.05%

0.00%
1994

1995

1996

1997

1998

1999

2000
11

2001

2002

2003

2004

autoquote was phased in, i.e. December 2, 2003, through July 31, 2003. We use the exogenous no

to identify
causality from algorithmic
for the endogenous
algo trad t/o,
iv regression
including
volatility,
price,trading
andto liquidity.
size We est
it

Lit = i + t + Ait + Xit + it

where Lit is a spread measure for stock i on day t, Ait is the algorithmic trading measure algo tra
share turnover,
market
Lit volatility,
= i +1/price,
t +and
Alog
Xitcap.
+ We
it always include fixed effects and time
it +
all explanatory variables, except that we replace algo tradit with auto quoteit . We regress by q
that are robust to general cross-section and time-series heteroskedasticity and within-group auto

Coefficient on algo tradit

Q1

Q2

Q3

Panel A: quoted spread, quoted depth,

qspreadit
-0.52** -0.42**
(-3.23)
(-2.21)
qdepthit
-3.47**
-1.43
(-2.50)
(-1.16)
espreadit
-0.18** -0.32**
(-2.65)
(-2.23)
Panel B: spread decompositions
rspreadit
0.35**
0.76**
(3.53)
(3.97)
adv selectionit -0.53** -1.07**
(-3.57)
(-4.08)
#observations: 1082*167 (stock*day)

Q4

Q5

Coefficients on
vola
share
turnoverit tility

and effective spread

-0.43
-0.16
9.92
(-1.44)
(-0.05)
(1.22)
-1.99
15.49
0.61
(-1.07)
(0.39)
(0.19)
-0.35
-1.63
4.65
(-1.56)
(-0.42)
(1.16)

-2.80**
(-3.01)
-5.16
(-0.64)
-1.01**
(-2.32)

0.90*
(9.70
-1.64
(-1.87
0.69*
(9.51

1.03**
(2.06)
-1.39**
(-2.06)

3.13*
(1.92)
-4.12**
(-2.24)

-1.06*
(-2.15
1.75*
(3.29

14.26
(0.46)
-15.48
(-0.47)

15.88
(1.36)
-11.21
(-1.33)

*/**: Significant at a 95%/99% level.

a
: We use quintile-specific coefficients for the control variables and time dummies. For brevity,
cap-weighted coefficient for the control variables and its t-statistic.
b
: We report the Dickey-Fuller test statistic based on the residuals in order to diagnose nonstati
that the series contains a unit root, i.e. it rejects nonstationarity.
12

details). As the LSB decomposition limits persistence to that of an AR(1) process, we also estimate a H
of the trade-related (stdev tradecorr compit ) and trade-unrelated (stdev nontradecorr compit ) comp
transactions (see Section 3.3.2 and Hasbrouck (1991a, 1991b) for details). For the regressions, we use
autoquote to instrument for the endogenous algo tradit to identify causality from algorithmic trading
estimate
M = + + A + X +

iv regression for lsb and hasbrouck decompositions

it

it

it

it

Mitor=Hasbrouck
i + component
+stock
Xiti +
t + Ait for
it t, Ait is the algorithmic trading me
where Mit is a LSB
on
day
including share turnover, volatility, 1/price, and log market cap. We always include fixed effects and ti
in the Hasbrouck component regressions. We regress by quintile and report t-values based on standar
and time-series heteroskedasticity and within-group autocorrelation (see Arellano and Bond (1991)).
Coefficient on algo tradit
Q1

Q2

Panel A: Lin, Sanger, and Booth (1995)

LSB95 f ixedit
0.26** 0.59**
(3.63)
(4.16)
LSB95 adv selit
-0.26** -0.61**
(-3.46) (-3.80)
LSB95 order persistit
-0.18** -0.30**
(-3.06) (-3.10)
Panel B: Hasbrouck decomposition
stdev tradecorr compit
-0.22** -0.26**
(-2.62) (-3.08)
stdev nontradecorr compit 0.13** 0.13**
(2.48)
(2.36)
#observations: 1082*167 (stock*day)

Q3

Q4

Q5

0.69**
(2.26)
-0.84**
(-2.14)
-0.21
(-1.60)

9.91
(0.46)
-12.19
(-0.46)
0.66
(0.28)

8.97
(1.36)
-7.72
(-1.32)
3.30
(1.21)

-0.30*
(-1.69)
0.13
(1.47)

-3.39
(-0.30)
1.03
(0.28)

-0.57**
(-2.73)
0.13
(1.12)

Coefficien
v
share
turnoverit t
2.35**
(2.07)
-2.58*
(-1.85)
-0.82**
(-2.33)

*/**: Significant at a 95%/99% level.

a
: We use quintile-specific coefficients for the control variables and time dummies. For brevity, we o
cap-weighted coefficient for the control variables and its t-statistic.
13

2. high-frequency traders as middlemen

Jovanovic and Menkveld (2010)

14

main findings
middlemen quickly process public news which in theory
solves no-trade deadlock between uninformed early investor
and informed late investor who trade through take-it-or-leave-it
(limit) orders (+)
creates adverse selection if both investors are uninformed (-)

empirically 07-08 sample belgian and dutch stocks shows

adverse selection is largest part of passive order markup
in-sample, chi-x (a venue friendly to middlemen) is introduced
for dutch stocks; coincidentally a highly active new middleman
shows up who
participates more when public news is important
trades primarily passive (80%)

a diff-in-diff analysis shows that the chi-x introduction

raised overall liquidity supply (+29%)
lowered volume (-13%)

15

main findings
middlemen quickly process public news which in theory
solves no-trade deadlock between uninformed early investor
and informed late investor who trade through take-it-or-leave-it
(limit) orders (+)
creates adverse selection if both investors are uninformed (-)

empirically 07-08 sample belgian and dutch stocks shows

adverse selection is largest part of passive order markup
in-sample, chi-x (a venue friendly to middlemen) is introduced
for dutch stocks; coincidentally a highly active new middleman
shows up who
participates more when public news is important
trades primarily passive (80%)

a diff-in-diff analysis shows that the chi-x introduction

raised overall liquidity supply (+29%)
lowered volume (-13%)

16

main findings
middlemen quickly process public news which in theory
solves no-trade deadlock between uninformed early investor
and informed late investor who trade through take-it-or-leave-it
(limit) orders (+)
creates adverse selection if both investors are uninformed (-)

empirically 07-08 sample belgian and dutch stocks shows

adverse selection is largest part of passive order markup
in-sample, chi-x (a venue friendly to middlemen) is introduced
for dutch stocks; coincidentally a highly active new middleman
shows up who
participates more when public news is important
trades primarily passive (80%)

a diff-in-diff analysis shows that the chi-x introduction

raised overall liquidity supply (+29%)
lowered volume (-13%)

17

main findings
middlemen quickly process public news which in theory
solves no-trade deadlock between uninformed early investor
and informed late investor who trade through take-it-or-leave-it
(limit) orders (+)
creates adverse selection if both investors are uninformed (-)

empirically 07-08 sample belgian and dutch stocks shows

adverse selection is largest part of passive order markup
in-sample, chi-x (a venue friendly to middlemen) is introduced
for dutch stocks; coincidentally a highly active new middleman
shows up who
participates more when public news is important
trades primarily passive (80%)

a diff-in-diff analysis shows that the chi-x introduction

raised overall liquidity supply (+29%)
lowered volume (-13%)

18

main findings
middlemen quickly process public news which in theory
solves no-trade deadlock between uninformed early investor
and informed late investor who trade through take-it-or-leave-it
(limit) orders (+)
creates adverse selection if both investors are uninformed (-)

empirically 07-08 sample belgian and dutch stocks shows

adverse selection is largest part of passive order markup
in-sample, chi-x (a venue friendly to middlemen) is introduced
for dutch stocks; coincidentally a highly active new middleman
shows up who
participates more when public news is important
trades primarily passive (80%)

a diff-in-diff analysis shows that the chi-x introduction

raised overall liquidity supply (+29%)
lowered volume (-13%)

19

main findings
middlemen quickly process public news which in theory
solves no-trade deadlock between uninformed early investor
and informed late investor who trade through take-it-or-leave-it
(limit) orders (+)
creates adverse selection if both investors are uninformed (-)

empirically 07-08 sample belgian and dutch stocks shows

adverse selection is largest part of passive order markup
in-sample, chi-x (a venue friendly to middlemen) is introduced
for dutch stocks; coincidentally a highly active new middleman
shows up who
participates more when public news is important
trades primarily passive (80%)

a diff-in-diff analysis shows that the chi-x introduction

raised overall liquidity supply (+29%)
lowered volume (-13%)

20

trailer
one brokers net position in ing on jan 30, 2008

21

correlations in the cross-section and through time

chi-x
minus
euronext quote
informativeness,
(PcPe )(f )
0.64

variable (units)

corr
type

CAPM R2 (%)

between

0.67

0.75

middleman
relative
use of
passive
orders
0.07

(0.27)

(0.27)

(0.27)

within

(0.27)
0.46
(0.05)

0.13

0.04

0.23

(0.04)

(0.07)

(0.08)

0.89
(0.27)
0.41
(0.05)

0.53
(0.27)

0.78

middleman particip. (%)

between
within

chi-x #trades (%)

between
within

middleman passive (%)

middleman
participation
rate

chi-x
share
#trades

(0.27)

0.08

0.20

(0.05)

(0.05)

0.23

0.67

(0.27)
0.15
(0.05)

(0.27)

0.05
(0.04)

between

0.52

within

0.02

(0.27)
(0.04)

14 stocks, 77 days

3. high-frequency trading and market structure

Foucault and Menkveld (2008), Menkveld (2010)

23

markets have fragmented. . .

FIGURE 1
NYSE % of consolidated volume in NYSE-listed
100.0%
80.0%

79.1%

60.0%
40.0%

25.1%

20.0%
0.0%
2005

2009

source: Securities and Exchange Commission (2010)

FIGURE 3
NYSE-listed consolidated
24 average daily volume
(billions of shares)

Secon

markets have fragmented (2). . .

17.5%
Broker-Dealer

19.4%
NASDAQ

7.9%
Dark Pools
1.0%
Other ECN

9.8%
Direct Edge

14.7%
NYSE

3.7%
Other Exchange
3.3%
NASDAQ OMX BX

13.2%
NYSE Arca

9.5%
BATS

NASDAQ
BATS
ECN: 2 Direct Edge
Broker-Dealer Internalization More than 200

NYSE
NASDAQ OMX BX
ECN: 3 Others

NYSE Arca
Other Registered Exchange
Dark Pools Approximately 32

source: Securities and Exchange Commission (2010)

25

2004: LSE introduces euroSETS to compete with Euronext

Foucault and Menkveld (2008)

26

proportion of smart routers ()

we estimate the proportion of smart routers, based on the
proportion of trade-throughs at times when EuroSETS shows
strictly better prices:

Q1
Q2
Q3
Q4
All

54%
22%
10%
23%
27%

37%
15%
5%
19%
19%

27

spread ratio against

FORA (Q1)

0.8

AABA (Q1)
RDA (Q1)

Spread NSC/ Spread EuroSETS

0.5
0.6
0.7

INGA (Q1)

AGN (Q
PHIA (Q1)

KPN (Q2)

AKZA (Q2)

MOO (Q

REN (Q2)
TPG (Q3)
WKL (Q3)
VNUA (Q3)

BUHR (Q4)

0.4

IHC (Q4)
HEIA (Q2)

AH (Q2)

GTN (Q3)
ASML (Q2)

HGM
(Q4)
DSM
(Q3)

0.00

0.05

0.10

0.15

0.20

0.25

0.30
0.35
0.40
Proportion SORS, (1i)

28

0.45

0.50

0.55

0.60

0.65

2007: Instinet introduces Chi-X to compete with Euronext

Menkveld (2010)

29

chi-x introduction, hft participation, bid-ask spread

18
16
14
12
10
8
6
4
2
0
20
10
0
10
20
30
40
50
60

25

Chi-X share Dutch trades (%, left axis)

high-frequency trader's participation Dutch trades (%, right axis)

20
15
10

start Chi-X
Mar 2007

Jun 2007

5
Sep 2007

Dec 2007

Mar 2008

Dutch bid-ask spread (treated) relative to Belgian benchmark (untreated) (%)

start Chi-X
Mar 2007

Jun 2007

Sep 2007
30

Dec 2007

Mar 2008

net position (euro 1 mln)

net position hft by market

euronext only

15
10
5
0
5
100

50

8
462
02
46
1080

50

1.0
0.8
0.6
0.4
0.2
0.0
0.2
0.4
0.60

100

150

200

100

150

200

50
100
150
days from Sep 04, 2007, to Jun 17, 2008

200

chi-x only

aggregated across euronext and chi-x

31

hft gross profit and capital employed

variable
gross profit per day (e)

large stocks
panel A: gross profit
1649

gross profit per trade (e)

positioning profit per trade (e)
net spread per trade (e)

small stocks

all stocks

55

1416

(50, 2751)

(47, 125)

(50, 2751)

0.99

0.19

0.88

(0.15, 1.62)

(0.18, 0.78)

(0.18, 1.62)

0.69

0.61

0.68

(0.90, 0.30)

(1.79, 0.07)

(1.79, 0.07)

1.68

0.80

1.55

(0.76, 2.15)

(0.25, 1.64)

(0.25, 2.15)

panel B: capital employed

actual capital employed
avg margin specific risk (e1000)
avg margin gen market risk (e1000)
max margin specific risk (e1000)

266

51

235

(50, 389)

(12, 70)

(12, 389)

95

18

84

(18, 139)

(4, 25)

(4, 139)

1545

410

1379

(73, 762)

(73, 2442)

(369, 2442)

max margin gen market risk (e1000)

461

89

407

(88, 674)

(21, 122)

(21, 674)

panel C: Sharpe ratio (based on realized maximum margin)

avg daily net return in excess of riskfree rate (bps)
8.01
0.41
st dev daily return (bps)

(2.39, 2.71)

(2.39, 17.60)

11.56

9.73

11.30

(8.27, 25.71)

annualized Sharpe ratio

32

6.90

(1.53, 17.60)

(4.20, 27.37)

(4.20, 27.37)

10.87

1.21

9.46

(2.93, 14.86)

(2.94, 4.60)

(2.94, 14.86)

electronic markets and high frequency

trading: same wine in new jars?
albert j menkveld
tinbergen institute, vu university amsterdam

december 2010

33

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High-frequency trading and its impact on market quality.
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34

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Informed traders in limit order markets.
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Does algorithmic trading improve liquidity?
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Algorithmic trading and information.
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Middlemen in limit-order markets.
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35

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36