Abstract
We study the impact on market liquidity of the introduction of a penalty for high order-to-trade ratios (OTRs), implemented by the Italian Stock Exchange to curtail high-frequency quote submission. We find that the fee is associated with a collapse in the quoted depth of the stocks that make up the bulk of trading in Italian equities and with an increase in price impacts of trading across the treated stocks. Spreads do not change, however. Stocks from a pan-European control sample show no such liquidity changes. Thus, the Italian OTR fee had the effect of making Italian stocks markets more shallow and less resilient. Large stocks are more severely affected than midcaps. We also find evidence of a limited decrease in turnover. Consolidated liquidity, constructed by aggregating across all electronic trading venues for these stocks, decreases just like that on the main exchange. Thus, liquidity was not simply diverted from the main exchange, it was reduced in aggregate.
Highlights
Declerck, Ian Marsh and Sebastien Pouget and two anonymous reviewers for their comments
We find that the deterioration of liquidity on the historical exchange extends to measures of consolidated liquidity
We find a clear picture of reduced liquidity supply, with quoted depth affected across the board and dramatically so for large stocks, whether at the best quotes or beyond
Summary
There is widespread interest in OTRs on the part of politicians, regulators and exchanges. At best, such orders are dismissed as not constituting genuine liquidity, while at worst, extremely short-lived quotes raise suspicions of abusive behaviour, the most obvious example being “quote-stuffing” (attempts to flood the systems of other firms with order entries and cancellations to hide manipulative behaviour.) Other manipulative strategies such as “layering” the order book or “spoofing” rely on the submission of multiple orders which are subsequently cancelled.3 These views are exactly what inspired the Italian OTR scheme – widely reported in the financial press to have been implemented at the request of the national regulators CONSOB (see Financial Times, February 20, 2012, and The Trade, February 27, 2012.) To a Finance commission of the Italian Senate, the Head of CONSOB gave more details on the rationale behind the fee, stating that “the ability of high frequency traders to suddenly cancel orders placed before they are executed, displacing other investors, can generate a misleading representation of the actual depth of the order book, creating favorable conditions for market manipulation.”. “the increase in the number of orders placed in the trading systems and in the orderto-trade ratio may endanger the regular course of the negotiations and the integrity of markets, given the limits on capacity and the reliability of the infrastructure.” This confirms that the OTR scheme was explicitly directed at HF traders and motivated by concern that their rates of order entry may disrupt markets and foster manipulation
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