The Provision of Liquidity by High‐Frequency Participants

Published date01 May 2014
Date01 May 2014
The Financial Review 49 (2014) 371–394
The Provision of Liquidity by
High-Frequency Participants
Elvis Jarnecic
University of Sydney
Mark Snape
University of Sydney
This paper examines the order submission strategies and supply of liquidity by high-
frequency participants versus the remainder of participants in the limit order book. The results
show that high-frequency participants submit orders at multiple prices in the limit order book,
concentrated at or within the quote. This activity translates into the provision of liquidity on an
on-going basis, which is robust to fast versus slow and volatile markets, together suggesting
that high-frequency participants resolve temporal liquidity imbalances in the limit order book.
The evidence is consistent with high-frequency trading (HFT) improving market liquidity,but
there remain issues surrounding high-frequency participants’ effect on market depth and the
difficulty of trading of non-HFT participants.
Keywords: high-frequency trading, London Stock Exchange, trading structure
JEL Classifications: G12, G14
1. Introduction
A complex relationship exists between the order submission strategies of par-
ticipants and the dynamics of securities prices, the assimilation of information into
Corresponding author: Room 444, H69, Economics and Business Building, University of Sydney,
New South Wales 2006, Australia; Phone: +61 2 9351 8708; Fax: +61 2 9351 6461; E-mail:
C2014 The Eastern Finance Association 371
372 E. Jarnecic and M. Snape/The Financial Review 49 (2014) 371–394
the market, the cost of trading, and the nature of liquidity. This relationship is further
complicated by the endogenous arrival of high-frequency participants, who have the
ability to submit, amend and cancel orders faster than most other participants. As
emerging and unique participants that employ innovativeorder submission strategies,
high-frequency trading (HFT) could challenge the current understanding of order
book dynamics and liquidity provision, as suggested by Hasbrouck and Saar (2009).
This paper explores the intertwined dynamics of order flow and liquidity supply
in the presence of HFT. There is on-going debate about the role of high-frequency
participants and whether they contribute positively to securities markets, since HFT
has been associated with an increase in order cancellations (especially those with a
short duration), small trade sizes, an increase in the complexity of trading (in particular
for other market participants), declining bid–ask spreads, and transitory price shocks.
Quantifying the contribution of various participants and trading strategies to liquidity
and trading difficulties of non-HFT participants can address various concerns about
the role of HFT, and assist practitioners who are looking to execute orders in this
This study examines HFT on the London Stock Exchange (LSE). The U.K.
trading environment is less fragmented than the U.S. equity markets, enabling more
direct and complete observation of HFT. Unique member identifiers for LSE trades
classify each order and trade into HFT and non-HFT, allowing direct examination of
the activity of HFT participants.
Prior studies examine limit order book dynamics and have provided researchers
and practitioners with a number of stylized empirical observations of the limit order
book.1However,given the advent and proliferation of HFT, these characteristics may
warrant reconsideration. High-frequency participants take advantage of short-term
inefficiencies in the market, and their order submission may be aggressive due to the
short-lived nature of their information. The existenceof HFT may also alter properties
of the limit order book, which may change with the emergence of a participant that has
a significant advantage in speed, and implements new order submission innovations
compared to past applications of the same trading strategies (see Hasbrouck and Saar,
2009; Angel, Harris and Spatt, 2011).
Given their advantage in speed and the short-term nature of their trading oppor-
tunities, HFT participants likely submit orders closer to the best quotes. To minimize
adverse selection and exposures risks, these orders might be frequently cancelled and
resubmitted. Hasbrouck and Saar (2009) suggest that small, short duration orders
significantly detract from the quality of liquidity. The order submission strategies
of HFT participants have subsequently been criticized for making it difficult for
investors to fill orders, and a number of non-HFT participants havecomplained about
1See, for example, Ahn, Bae and Chan (2001), Biais, Hillion and Spatt (1995), Handa, Schwartz and
Tiwari (2003), Hollifield, Miller and Sandas (2004), Griffiths, Smith, Turnbull and White (2000), and
Ranaldo (2004). However,these generally focus on limit order books containing public supply of liquidity
from human traders, sometimes with the inclusion of a designated market maker.

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