Could stock markets become less liquid and more opaque due to high-frequency trading?

This was the conclusion of a study led by Northwestern’s Kellogg School of Management Professor Joshua Mollner and researcher Markus Baldauf of the University of British Columbia.

Here is an excerpt from an article published by Kelllogg Insight:

The impact of high-frequency trading, the researchers found, depends on the specific type of investment strategy being used. On the one hand are the high-frequency market makers, or traders who offer to buy and sell a given stock and make money from the price difference, or the spread.

“They’ve gotten really good at managing the risk of trading with someone who might know more than they do—someone who might buy only when the price is likely to go up and sell only when the price will go down,” Mollner says. “That ability helps them operate profitably even while charging a fairly small spread. Their presence leads to more liquid markets.”

On the other hand are high-frequency arbitrage traders, who assess where prices are going literally in the next milliseconds, then try to trade in the most profitable direction. “One of these traders might be monitoring the market and get the sense that some big trader out there is buying, so prices are going to go up, and they’ll start buying as well,” Mollner says. “Effectively they’re amplifying whatever the informed traders are doing.”

While this form of arbitrage can be profitable for the trader, the researchers’ model showed that it can cause problems for the market. Why? Because that amplification of better-informed traders’ moves, in turn, makes things riskier for market makers, forcing them to charge a larger spread to be profitable and ultimately reducing market liquidity. And in addition, high-frequency arbitrage also leads to less informative prices.

“If I’m a trader who’s done some fundamental research and acquire some information but I’m in a world of super-fast high-frequency traders, I’m not going to be able to trade much volume before they figure out what I’m up to,” Mollner says. “That weakens my incentives to do the research in the first place.”