Fast Traders Create Illusion in Treasuries, N.Y Fed Says

  • Canceled or modified trades help form mirage of market depth
  • High-frequency firms do aid efficiency, tighter price spreads

The fastest movers in the $12.8 trillion Treasury market, known as high-frequency traders, are making it more challenging for investors to assess the depth of the market, according to research from the Federal Reserve Bank of New York.

After examining trading across the most active platforms, including futures through CME Group Inc. and cash Treasuries on ICAP Plc’s BrokerTec and Nasdaq OMX Group Inc.’s eSpeed, the researchers found evidence that high-frequency traders create an illusion of liquidity in the Treasuries market. 

Investors often submit orders to buy or sell to multiple trading venues in an effort to get the most competitive prices. High-frequency traders are able to detect orders that are completed on one trading platform and then cancel or alter their offers on others before they are filled. Thus, the prices on multiple platforms makes it appear as if there is more trading interest than is actually the case, the researchers found.

Trade Patterns

They pointed out a trade that may be completed by an investor on BrokerTec.

"As soon as the BrokerTec transaction is observed in the market data feed, co-located low-latency market participants may immediately seek to cancel top-of-book offers on eSpeed and CME or submit competing buy orders to eSpeed and CME," researchers Dobrislav Dobrev and Ernst Schaumburg wrote on the N.Y. Fed’s blog. Top-of-book orders reflect the highest buy and the lowest sell prices. Low-latency is another term for the high-speed trading technology.

"The striking cross-market patterns in trading and order-book changes suggest that quote modifications/cancellations by high-frequency market makers, rather than preemptive aggressive trading, are an important contributing factor to the liquidity mirage phenomenon," the researchers wrote.

The mirage arises because "market participants respond not only to news about fundamentals, but also market activity itself," the researchers wrote. "This can lead to order placement and execution in one market affecting liquidity provision across related markets almost instantly."

The researchers "did not find any evidence that the liquidity mirage was more pronounced on Oct. 15 compared with our control days." On Oct. 15, 10-year yields in the Treasury market dropped by 34 basis points, or 0.34 percentage point, before returning to end the day lower by only six basis points.

The blog post noted that high-frequency traders strengthen market efficiency and help to ensure that "market makers can maintain tight spreads and that consistent pricing of closely related assets generally prevails." That benefit, however, "comes at the cost of making the real-time assessment of market liquidity across multiple venues more difficult," the researchers said.

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