Automated equity trading: The evolution of market structure and its eect on volatility and liquidity

David Weisberger and Paul Rosa

Two Sigma Securities david.weisberger@tssecurities.com

2013.06.19

Abstract An oft-repeated maxim is that volatility in the US equity markets has increased over the past several years and that the rising use of automation is the cause. In contrast, we believe that the issues that investors often attribute to automation are due to dierent factors. Firstly, we show that, despite this widely held perception, there is little numerical evidence that overall market volatility has increased materially over the past decade. Secondly, we demonstrate that changes in market structure created some of the vulnerabilities in the equity marketspecically, that regulation has lowered the nancial incentives for capital commitment. Thus, oversized individual orders which are larger than the immediately available liquidity can create sharp price movements. Such orders normally result from manual order entry but can also occur when algorithms have insucient control parameters. Fortunately, more recent regulation such as circuit breakers and the new Limit Up / Limit Down regime should help to address these risks.

Two Sigma Securities, LLC (TSS) is a broker-dealer that makes markets in over 7,000 securities, and is a member of the Financial Industry Regulatory Authority, Inc. and 11 equity U.S. exchanges. The views expressed herein represent only the opinions of the authors and not necessarily the views of TSS or any of TSSs aliates.

CONFIDENTIAL - NOT FOR REDISTRIBUTION. THIS REPORT IS PREPARED AND CIRCULATED FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY. PLEASE SEE THE FINAL PAGE OF THIS DOCUMENT FOR IMPORTANT DISCLAIMER AND DISCLOSURE INFORMATION.

Introduction

There is little doubt that the amount of automated trading in the equity markets has increased rapidly in the past one to two decades. Near the end of the 1990s, almost all trades were executed individually by traders or via the specialists at the NYSE. Automation was beginning to gain traction, but was used for order delivery (DOT), order grouping (program trading) and order matching (primarily ECNs such as Island and Instinet). More recently, however, automation has come to dominate smart order routing, the handling of institutional orders, and market making. After multiple discussions with industry executives, we estimate that the majority of institutional trades are now handled electronically and most retail trades are handled via automated market making. Public opinion regarding automation is largely negative. There is pervasive thinking that automation is responsible for higher volatility in the markets and that this is indicative of a game that is rigged against retail investors. The frequency of news stories on aberrant intraday price uctuations seems to have increased, and policy makers are devoting signicantly more attention to the issue (e.g., SEC roundtable on. . . ). However, we maintain that these beliefs have received an unwarranted amount of media attention and are not supported by statistical evidence. By two dierent volatility measures that we discuss in the next section, there is little data to support the assertion of increased systemic volatility over the past decade (with the exception of the 2008 Financial Crisis, which was unrelated to market automation). We agree that the current market structure is vulnerable to large price dislocations in single stocks, but we believe that this weakness developed as a side eect of Regulation NMS, which was implemented in 2007.1 This regulation was instrumental in encouraging the growth of automation by enhancing competition among market centers, but it also reduced both the incentive and the means for market participants to commit capital that would provide a buer against oversized orders. Overall, we believe that automation has been positive for the markets. Lower average bid / oer spreads indicate that market liquidity is better now than it was in the early 2000s, prior to the rapid growth of automated trading. Trading costs are also dramatically lower. For example, according to a recent report by Credit Suisse, trading costs for institutional investors decreased 30% between 2005 through 2012 [1]. Furthermore, according to data published by Thomson Reuters, retail trading costs have declined even more. The widely1

For more information on Regulation NMS, see the SEC release at http://www.sec.gov/rules/final/ 34-51808.pdf (accessed 2013.05.10).

used metric of eective spread divided by quoted spread2 indicates that costs have fallen by more than 35% between January 2006 and January 2013.

A numerical analysis of volatility

In order to evaluate whether overall market volatility has increased in recent years, we looked at two dierent measures: intraday price swings of individual stocks and longerterm market volatility, as measured by the CBOE Volatility Index (VIX). We realize that there are other metrics that one could use, but these two (particularly intraday volatility) are most closely related to the market structure changes we discuss in Section 3.

2.1 Intraday volatility

As a proxy for intraday volatility of individual stocks, we analyzed the average daily price moves of the securities in the S&P 500 Index.3 With the exception of 2008 and 2009, there are no major dierences in measured volatility over the time period (in fact, intraday volatility in 2012 was equivalent to the levels seen in 2004 through 2006 and approximately 50 basis points below levels observed in 2007):

Figure 1: Average intraday volatility for all S&P 500 stocks, measured as the dierence between a stocks high and low price over the open price. The high, mid and low points of the boxes represent 75th, 50th and 25th percentiles of volatility, respectively. The ends of the whiskers mark the 5th and 95th percentiles
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This measure is also known as EOQ, where eective spread is two times the dierence from the mid spread to the executed price, while quoted spread is the full spread at the time an order is received. It is published for all market makers pursuant to SEC Rule 605. - LowPrice 3 We dene intraday volatility as HighPrice . To limit selection bias, when we calculated the daily OpenPrice average volatility, we included all stocks that were part of the index on the given day.

To determine whether the averages of the entire universe concealed large moves among the most volatile stocks, we performed a separate analysis of the top 5% and top 1% most volatile daily moves over the period.4 Once again, we were unable to detect any notable shifts in volatility:

Figure 2: Average daily volatility for the top 1% of moves on each day

Figure 8 in the Appendix shows a similar result for the top 5% of moves. Lastly, in order to control for market eects, we analyzed the volatility of the idiosyncratic return5 measured against the S&P 500 Index (SPY). Like the unresidualized volatility, periods outside of 2008 and 2009 are comparable:

We created these new datasets by culling the original selection of 500 S&P stocks to the top 5% and 1% (25 and 5 stocks, respectively) with the largest percentage swings on each day. 5 We dene idiosyncratic return as the dierence between a given stocks intraday price move and the price move of SPY on that day. Thus, if stock XYZ moved 10% during the day and SPY moved 7%, the idiosyncratic return would be 3%. It is this 3% value that we measure across the period, rather than the 10% value as we would have in the previous dataset.

Figure 3: Average daily residual volatility for all S&P 500 stocks

The same analysis for the top 1% and 5% can be found in the Appendix.

2.2 VIX
A commonly cited gauge for overall market volatility is the VIX, which measures the implied forward volatility of options on the S&P 500 Index. Figure 4 shows the daily price of the VIX from 2002 to 2012. From this plot it is quite clear that volatility has uctuated signicantly over the period, but the 2008 Financial Crisis and subsequent are-ups in Europe in 2010 and 2011 dominate the graph. The past 6 months have seen the VIX settle to levels near historical lows despite ever-increasing automation:6

The two spikes following the 2008 Financial Crisis correspond to May 2010 and August 2011. May 6, 2010 marked a nationwide strike in Greece against proposed government austerity bills, the rst of several major protests against these programs [2]. In the US, this was also the date of the Flash Crash in the equity markets. August 2011 reected the downgrade of the United Statess credit rating from AAA by S&P and the markets subsequent anxiety over the political discussions to raise the countrys debt ceiling [3].

Figure 4: VIX daily price from 2002 to 2012. The line represents the historical low of 9.31 on 1993.12.22

Vulnerability in the current market structure

While some concerns of increasing systemic volatility over the past few years are not supported by numerical evidence, we do believe that there is a aw in the current market structure that makes it vulnerable to large price dislocations in single stocks. We maintain that some discussions of increasing market volatility mistakenly equate these single-stock price dislocations with overall volatility, but we have shown that they have not impacted our chosen systemic statistical measures. Furthermore, when such disturbances occur, they are likely to be caused by oversized orders entering the marketplace in error (from manual order entry or poorly designed or controlled algorithms) rather than automated trading. The current equity market structure, while highly automated and ecient, has engendered a market that is vulnerable to large, price-insensitive orders that exceed the size of the available liquidity in the rst few levels of the order book. In response to the trade through protection of Regulation NMS, market makers now have considerable nancial incentives to concentrate available liquidity very close to the current price of an instrument and have nancial disincentives to provide liquidity away from the quote. Furthermore, this protection applies only to automated quotations. As a result of these developments, market making has shifted away from block trading and towards automated trading algorithms. 6

We demonstrate below that oversized orders now have the potential to create large, rapid movements in the price of an instrument in a way that they could not prior to the implementation of Regulation NMS. For example, the fast quote provision forced the NYSE to severely restrict the ability of exchange specialists to manually execute trades, thereby reducing their ability to moderate the entry of large orders directly into the market.7

3.1 Market structure before Regulation NMS

The market structure prior to the implementation of Regulation NMS was relatively insensitive to block trading. To illustrate why, we examine Figure 5, which shows what the hypothetical liquidity density curve for a stock would have looked like before Regulation NMS. It charts the total volume available for trading (both displayed and undisplayed) at various bid / oer levels away from the current quote. We see that specialist rms and bulge-bracket market makers were willingand, more importantly, permitted to evaluate and transact block trading opportunities, either outside of the market (in the case of NASDAQ) or on an arranged basis (such as on the oor of the NYSE), at prices higher or lower than the market when asked to do so by their institutional clients:

Figure 5: Theoretical chart of volume available from block positioners in reaction to an institutional order prior to Regulation NMS

While there is no statistical method for evaluating this data directly (since the actionable liquidity was not displayed), we can estimate the natural liquidity prole of market
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The trade through requirement of Regulation NMS was designed to improve posted liquidity on National Securities Exchanges, with the goal of tightening spreads and lowering trading costs. It did not, however, include a block trading exemption.

makers. A reasonable estimation can be found in representations of marginal utility curves presented in academic research. Consider the following excerpt from Robert Almgrens 2001 paper [4]:

Figure 6: Excerpted from Nonlinear Optimal Execution

This graph represents the price-to-liquidity function from the perspective of a block trader. Note that the slope of h(v ) is relatively at for small block sizes but increases quickly as the trade size grows. We believe that this is indicative of the theoretical model used by block desks to price liquidity. As an example, consider how an institution might have executed a large order prior to Regulation NMS. Assume that a manager would like to sell 1 million shares of stock XYZ, with 25,000 shares displayed at the market. Since the order far exceeds the displayed volume of the stock, the institution would likely have wanted to obscure the trade so as to prevent information leakage and to do so they would have used a market maker to provide block liquidity for all or part of the order. Assuming that the price was bid at $17.32 and oered at $17.33, the market maker may have oered it several possible options: 1. Sell all 1 million shares to the market maker at $17.27 plus commission (typically around 6 cents in 2002) 8

2. Sell 500,000 shares at $17.30 to the market maker and allow the market maker to work the balance (500,000) on an agency basis directly in the market, charging the 6 cents commission on the whole block 3. Sell 200,000 shares at $17.32 to the market maker and allow the market maker to work the balance (800,000) on an agency basis directly in the market, charging the 6 cents commission on the whole block This demonstrates the pricing exibility that the market maker would have had, as the liquidity provider was able to adjust its nancial incentives according to the amount of risk that it would be absorbing. In addition, this structure made it extremely rare that large trades would be entered directly into the market.8

3.2 Market structure now (post-Regulation NMS)

Regulation NMS specically disadvantaged market makers from pricing and trading block liquidity as shown in Figure 6 above by requiring that resting orders at the top of the book on all protected markets be given trade through protection, regardless of the size of the order. In most cases, this has the eect of forcing market makers to sweep the displayed composite market liquidity all the way to the price that they want to trade. For the XYZ example above, the market maker would likely have been forced to sell shares down to the price of $17.28 (1 cent above the institutions bid price in the rst option) before buying the stock from the client at $17.27. For any traders watching the market, this pattern would signal a large seller currently engaging, signicantly raising the risk for the market maker providing the liquidity. Regulation NMS was also the direct catalyst for changes to the NYSE market structure. Due to the provision that allowed other market participants to essentially ignore slow quotes, the ability of the specialists (renamed to Designated Market Makers, or DMMs, after the regulation) to evaluate incoming orders and survey the oor for liquidity was essentially eliminated. The NYSE became almost fully electronic, with human intervention limited to the opening and closing auctions. Electronic trading by nature involves less human oversight, which means that fat nger mistakes and other trading errors are less likely to be noticed before being executed. It is worth pointing out that, before Regulation NMS, specialists and NASDAQ market makers
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If a large trade did pass to the market, it was usually the result of a poorly constructed program trade or a fat nger type of error. In any case, the specialist on the exchange would hold up the order until necessary liquidity was assembled to ll it.

would sometimes detect trading mistakes and intervene to minimize market disruptions. The regulation made it less protable or simply impractical to employ people to scrutinize orders, due to the combination of reduced nancial incentives for block trading and the removal of protection for slow quotes (i.e., the times when a trader would intervene to slow down an order). Thus, the markets lost a layer of protection. As a result, institutions have adapted by dramatically increasing their use of algorithmic trading to implement their trading decisions. Algorithms are typically designed with controls to detect orders that are too large for the market at the time of the trade, but this will not always detect errors as there can be aws in the controls and not every order is entered via an algorithm. Since there are still orders that are entered to exchanges directly by participants and these orders have much less oversight now than they did prior to Regulation NMS, the fact that the average liquidity in todays market is disproportionately skewed towards the current price of each stock constitutes a potential vulnerability. To illustrate, consider the actual depth-of-book pattern in Figure 7 below. Similar to the hypothetical example in Figure 5, it charts the volume available for trading (including all displayed orders on protected exchanges) on the Y axis and the price of the instrument (as a ratio of the spread) on the X axis:9

To produce this graph, we gathered daily depth-of-book data for up to 10 price levels away from the quote for all the constituents in the S&P 500 during 2012. For each level n, we calculated: (1) the Bidn Bid0 n Ask0 spread ratio, where: spread ration = Ask Ask0 Bid0 (or Ask0 Bid0 for the opposite side of the book); and, (2) the total number of shares displayed at that level. Next, we aggregated the same multiples across the time periodso if Day 1 indicated 100 shares at 1x the displayed spread and Day 2 indicated 200 shares at 1x the displayed spread, the total of the two days would be 300 shares at 1x the displayed spread. Lastly, for smoothing, we rounded decimals to their nearest whole multiple (values less than X.5 were rounded to X, values greater than or equal to X.5 were rounded to X+1).

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Figure 7: Actual dept-of-book liquidity for S&P 500 stocks in 2012

This liquidity prole, coupled with market makers decreased incentives to buer large orders, is indicative of a market where an order that is larger than the displayed size can have a signicant impact on price. Note that the representation of liquidity presented by Almgren in Figure 6 still holds in this market, but very few market makers are willing to act on it directly due to the disincentives discussed earlier. The main outcome is that modern market makers place orders at prices where they are likely to be executed. In the current environment, orders placed far from the market have a number of disadvantages compared to those placed close to the current bid / oer, including: The order may only get lled at a time when the securitys price would continue to move against the order (this is typically referred to as adverse selection) All open orders are considered by rms risk control systems when monitoring their net capital, so leaving multiple unexecuted orders at dierent price levels is disadvantageous to capital Market makers have reputational incentives to have a high execution percentage, due to negative connotations associated with a low executions-to-orders ratio Whether the market maker is employing a human or an algorithm to trade, the orders will operate on these same basic risk principles.

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3.3 2010 Flash Crash

The market-wide Flash Crash on May 6, 2010 was a real-world example of the structural deciency that Regulation NMS may engender in the equities market. The futures market already has many of the structural characteristics that Regulation NMS has created for equities, including trade through protection. In the CFTC-SEC report on the crash, the analysis concluded that a trader placed into a trading algorithm a SPY futures order that was signicantly larger than the available liquidity in the market at the time and the algorithm did not account for these conditions. As a result, the trading algorithm placed orders that rapidly depleted the posted liquidity, resulting in a large downward move in the market. Index arbitrageurs then sold the stocks in the underlying index (mostly using market orders) as they provided liquidity to the ETF seller. This, in turn, triggered extreme movements in several stocks in the S&P 500 Index as the orders outstripped available liquidity. After that, stop loss market orders, which by their very nature are designed to trigger when there are large price moves, continued to drive stocks downward, several of them to the minimum price in the order book [5]. This was fundamentally a liquidity issue, albeit an extraordinary example with the backdrop of rumors of a Greek default and riots in the streets of Athens. We do, however, believe that the liquidity decit in individual stocks was exacerbated in part by the protection given to resting orders at the top of the book and the resulting lack of liquidity away from the original quote.

Conclusion

We do not see evidence of increased systemic volatility to the degree that is being asserted in media reports. However, we have described a structural weakness in the U.S. equity market that makes single stocks susceptible to rapid price swings due to large orders. The vulnerability manifests itself whenever market participants demand more liquidity than is instantly available. In such cases, the price of the security can move dramatically due to the concentration of orders close to the current price. We believe that some discussions of volatility are referring to these one-o events, rather than overall market volatility. Recently, regulators have introduced several corrective remedies to help address this weakness. Subsequent to the 2010 Flash Crash, regulators tightened the bands on marketwide circuit breakers, which will help to contain damage if a similar scenario repeats. They also introduced single-stock circuit breakers to try to limit the size of moves that

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result from individual stock liquidity disruptions. Furthermore, the implementation of the Limit Up / Limit Down (LULD) rule10 will hold the magnitude of intraday price swings to more acceptable levels. The rule also includes built-in time delays so that after trading is halted due to large price swings, liquidity providers will have sucient time to become re-engaged subsequent to the re-opening auction.11 Finally, we do not believe that increasing automation is the root cause of this liquidity issue, but rather the logical outgrowth of market makers responding to specic economic incentives. We also do not believe that a trade-o between automation and liquidity is necessary. To the contrary, the transition to increased automation has been positive on an aggregate basis, as automation can continue to deliver increased liquidity, tighter bid / oer spreads and improved overall execution quality. However, it is incumbent on market participants to build protections into their algorithms against outstripping available liquidity. We believe this to be an essential component of the algorithmic development process. As the majority of participants enhance their algorithms to be sensitive to liquidity, the markets resilience to large orders will improve.

References
[1] Mackintosh, Phil. How Much is Market Structure Hurting Investors?. Credit Suisse Trading Strategy, 2013.03.13. [2] Bilefsky, Dan. Greek Parliament Passes Austerity Measures The New York Times. New York Times, 2010.05.10 (accessed 2013.02.28). [3] Nazareth, Rita. U.S. Stocks Fall as S&P 500 Has Biggest Slump Since November 08 Bloomberg. Bloomberg, 2011.08.08 (accessed 2013.02.28). [4] Almgren, Robert. Nonlinear Optimal Execution. University of Toronto, Departments of Mathematics and Computer Science. http://www.math.nyu.edu/~almgren/papers/ nonlin.pdf [5] CFTC-SEC. Findings Regarding The Market Events Of May 6, 2010: Report Of The Stas Of The CFTC And SEC To The Joint Advisory Committee On Emerging Regulatory Issues. 2010.09.10 (accessed 2013.03.01).

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The LULD rule prevents the trading of equity securities outside of specied price bands, established as a percentage level above and below the average price of the security for the previous ve minutes of trading. 11 For more information on the circuit breakers and the LULD rule, see the SECs press release at http://www.sec.gov/news/press/2012/2012-107.htm (accessed 2013.03.01).

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Appendices
A Additional volatility graphs

Figure 8: Average daily volatility for the top 5% of moves on each day

Figure 9: Average daily residual volatility for the top 1% of moves on each day

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Figure 10: Average daily residual volatility for the top 5% of moves on each day

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