The liquidity provided by high-frequency traders in highly liquid stocks may be costing institutional investors more than they think, according to new research from US-based trading technology firm Pragma.
According to the new white paper, the combination of maker-taker pricing tariffs on exchanges and penny tick sizes distorts the market and forces investors to subsidise the activity of high-frequency trading (HFT) firms.
Pragma’s study looked at the disproportionately long queues that are common when trading ultra-high liquid stocks. Queues in these stocks, which are characterised by high volumes, low volatility and narrow spreads, are a result of the huge number of HFT orders competing to provide liquidity, which far outweigh aggressive orders.
This high proportion of passive orders forces directional traders to cross the spread more often, increasing institutional investors’ trading costs by several basis points compared to moderate volume stocks.
“Although competition among market makers narrows spreads, the research note shows that reduction in spread is more than offset by the fact that market participants are effectively forced to trade through unwanted intermediaries, resulting in inferior execution prices,” read the paper.
By comparison, stocks priced below US$1 have a narrower tick size and a rebate that is far lower than those offered on stocks over US$1, which discourages HFT activity, according to the paper.
“From a market structure perspective, the concern is that there is no practical way to opt out of interacting with these superfluous market makers, and because of the take fees charged by exchanges, directional traders are effectively forced to subsidise HFTs even though there are other directional traders they could interact with directly,” the paper read.
To help improve market quality for institutional investors, Pragma suggests regulators should eliminate or limit the rebates offered by exchanges for providing liquidity and reduce the tick size for stocks priced between US$1 and US$0.001. This, claimed the firm, would help the market settle on more reasonable spreads in liquid stocks and reduce profits made by HFT firms at the expense of institutional investors.