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The High Frequency Game Changer: How Automated Trading Strategies Have Revolutionized the Markets by Sang Lee, Paul Zubulake

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Chapter 4

Liquidity

Loosely defined as the ease with which a market can facilitate buyers and sellers of securities with minimum level of friction, liquidity is the foundation of the capital market. Not so long ago, liquidity providers in the equities market were regulated market makers and specialists, who were legally bound to market two-side markets and provide liquidity into the market in exchange for access to market information that gave them an advantage over other market participants.

However, with the rapid adoption of electronic trading and democratization of available market information, the role of traditional liquidity providers has changed drastically. In fact, the concept of traditional market makers and specialists no longer has a strong footing in the U.S. equities market. In the overall evolution of the equities market structure, high frequency traders are often viewed as the next generation liquidity providers.

HFT AS LIQUIDITY PROVIDERS

Electronic markets need electronic market makers; there is no other way of displaying tradable prices other than through an algorithm. Standing in front of a freight train of buyers or sellers is not an easy endeavor. Liquidity providers are not in the business of losing money and if the rules are changed to impede the potential of making profits, the amount of tradable prices will decline and the bid/offer spreads will widen. This debate will continue but the reality is the cost of trading will increase for all market participants. ...

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