I have had a number of posts on liquidity over the past few years, in an attempt to explain an ill-understood phenomenon. Here is a sampling:
- What is Liquidity? (one of my first posts)
- What is Liquidity? (Part II)
- The Five Pillars of Liquidity
- Nonidentical Twins: Solvency and Liquidity
- Nonidentical Twins: Solvency and Liquidity, Redux
- The First Priority of Risk Control
Because of high frequency trading, I want to take another stab at what liquidity is. Limit orders offer liquidity; an investor or market maker offers to buy or sell at a fixed price. Market orders consume liquidity — they lift or hit limit orders, often forcing the bid-ask spread wider.
But not all limit orders are the same. They vary because:
- Some limit orders narrow the bid-ask spread, which aids liquidity.
- Some limit orders bid/offer more shares, which increases liquidity.
- Some limit orders hang out there for a long time, which also boosts liquidity.
Liquidity means being able to make a choice, and if possible to do it in size, at a price that you like. Also, for many of us, it means that we have some amount of time to think about the price. That is liquidity — the ability to buy or sell in size without having to “bust a gut” to do so.
High frequency traders claim to add liquidity, but their bids and asks are ephemeral. They add little liquidity, because the average investor can’t act on them. They are like market orders, because they are gone in a flash, consuming longer-dated liquidity.
I am not saying that high frequency trading should be illegal, but that investors and market makers should carefully consider the rules where they trade. For investors: are you trading in a market where you have a disadvantage? For market makers: you should be the heavy hitter here; don’t let anyone more powerful/fast in. Operate your market for the best interests of all, and ignore those that want an advantage. In some cases this may mean executing trades once every five seconds, or any such similar interval.
Level playing fields promote broad markets. Let clever market makers so structure their businesses, that level playing fields dominate investing.
I generally enjoy your articles but believe that you have this one wrong. Market Makers are hi-frequency traders. The systems that execute orders for clients are also hi-frequency systems. Providing a bid for 100ms is useful to most of today’s (equities/futures/fx) market participants.
Limit orders that last longer offer more liquidity to the market than those that flash and disappear. That is all I am saying. If really short-term orders offer liquidity, it is very small, because the time to take advantage of it is short.
But, I want to learn. Please point me to the pro-HFT writings that will truly instruct me. I would like to see the case, but I have not seen it anywhere.