Micro stock trade innovation can help macro market liquidity

Stock market liquidity is essential to well-functioning markets. Liquidity describes the availability and cost of buying or selling a specific quantity of a security. When investors entering the market need to buy securities, or when investors need to sell, liquid markets help to ensure that their trades have a limited impact on current market prices. 

Illiquidity can be the spark to light a market panic, and even if the panic turns out to be temporary, losses from the dislocation can be substantial, as we have seen from past events.

The Federal Reserve’s most recent financial stability report, in November 2019, warns there were two specific episodes of liquidity panics in equity options markets in 2019 alone. The Fed’s concern about diminishing equity market liquidity is that it threatens the financial system’s resilience to shock.

The Federal Reserve’s verdict on the post-2008 market is that “flash events appear to have become modestly more frequent in equity futures” and “illiquidity has become more fragile over time.” Central bankers use phrases like “modestly more fragile” for risks most of us would use much saltier language to describe.

The Fed diagnoses this liquidity problem as a result of two shifts in institutional dynamics: Fewer principal trading firms providing liquidity and increased concentration among firms that do. Another result has been trade migration to dark pools and increased fragmentation. Markets participants are wary of the market intermediaries that now provide most equity liquidity. And who could blame them? Put another way, traditional market makers have largely withdrawn from the business of equity market making, leaving the business predominantly to high frequency traders who are able to succeed amid the high-speed gamesmanship that defines today’s equity markets. 

For the more ordinary market makers, latency arbitrage imposes a constant structural risk. As market information travels between markets at various speeds, partly based on the tiers of speed that exchanges themselves sell, there is vast potential for latency arbitrage opportunities that can cause a resting limit order to suddenly execute at a stale or inferior price.  

Latency arbitrage isn’t legitimate trading about underlying value leading to price discovery. It is artificial trading using a speed advantage to tax normal market transactions. A study released by the United Kingdom’s financial regulator on Monday estimated that trades on U.S. exchanges lose $2.8 billion per year as a result of latency arbitrage. Many market experts might say this estimate is very conservative.

Who can blame slower institutional brokers who fear posting trades on this market, only to be taxed by faster traders who can anticipate their trades and get ahead of them? 

This is a macro level problem. But micro level innovations are already popping up to address the issue in the form of new market innovations designed to arm slower traders with defensive tools that can help protect them from faster traders. 

Case in point is Investors Exchange’s new Discretionary Limit order type, which is pending review by the Securities and Exchange Commission. It links a displayed limit order with a pre-determined algorithm designed to act as an umpire that pulls the price one step away from the prevailing best price (or NBBO) when the algorithm detects that the order is about to be picked off by a high-speed trader who is abusing advanced market information obtained through latency arbitrage. 

Stock market order types have been described as exhibiting a natural tendency to evolve. There are two types of evolution: First, apex predators who evolve at the expense of the rest of the ecosystem; and second, sustaining food sources that maintain ecosystem balance. The D-Limit order type described in its open application is the latter type. 

If market makers, brokers and investors can more reliably avoid a share of the $2.8 billion annual latency arbitrage tax with defensive tools like D-Limit, they can encourage an ecosystem of a diversity of traders to reenter the displayed markets and encourage trades in dark pools to migrate back to lit venues where it is safe to post a quote. 

The D-Limit proposal gives discretion to IEX’s system — it does not empower the user to control the timing of the discretionary action; hence the broker or market maker using the order type has no ability to abuse the order type through discretion. Instead, the order type extends to all who want to use it. 

In short, the D-Limit innovation provides all market participants the ability to rent a tool in a non-discriminatory manner to defend themselves against latency arbitrage. It’s like a missile defense shield for smaller traders who cannot afford to participate in the high-speed arms race.

If the SEC takes a permissive approach to approving new innovations like these, traders will migrate back from dark pools to the more transparent and liquid markets. Despite the foul cries of other exchanges and some high-speed traders, the SEC has a responsibility to address the needs of all participants with respect to the quality and health of the markets. 

The result of a market innovation like D-limit will be a more liquid equities market that is more resilient to market shocks than today’s market, which should make D-limit a candidate for high-speed approval. 

J.W. Verret is an associate professor at the George Mason University Antonin Scalia Law School.