In this note we review the rapidly expanding literature in the area of market microstructure, high frequency and computer-based trading. On the back of this and based on our own investment and trading experiences, we highlight issues of concern to large long-term global investors.
The nature of equity markets has evolved with the advent of computer-based trading (CBT) and high frequency trading (HFT). Some market observers have been critical of HFTs and this topic has become controversial.
HFTs do not constitute one coherent entity and their trading strategies can vary. It is therefore important to address their contribution to and impact on market quality and efficiency with such differences in mind.
There is little consensus yet on what constitutes an appropriate framework for assessing market quality. More emphasis can be put on time-variation in trade-related measures including market impact across trade horizons that is more typical of large institutional order flow.
Regulatory policies should try to take into consideration intended as well as unintended consequences given complexity in market microstructure. Introduction of new policies should consider potential negative impact on liquidity provisioning without robust alternatives in place.
In our view, issues of concern to large, long-term investors more deserving of attention include –– Anticipation of large orders by some HFTs leading to potential adverse market impact –– Transient liquidity due to high propensity for HFTs to rapidly cancel quotes real-time –– Un-level playing field amongst market makers from low latency ultra HFT strategies
On the broader implications for well-functioning markets, we address three aspects – implicit transaction costs, market abuse and equality, and endogenous and systemic risk. In our view, more research and debate is needed in these areas.
Markets will continue to evolve. The recent emergence of HFTs is an indication that continued research and development of trading strategies, as well as debate on appropriate market structure, are important responsibilities of asset managers and other market participants.