Fed warns on liquidity mirage for US treasuries.
Making a real-time assessment of market liquidity across multiple venues is more difficult due to high-frequency trading (HFT) in US Treasury markets, according to a paper written by Ernst Schaumberg, assistant vice president to the Federal Reserve Bank of New York’s Integrated Policy Analysis Group and Dobrislav Dobrev, an economist at the Board of Governors of the Federal Reserve System.
Noting the positive effects of HFT, such as the instantaneous reaction of the market to information which allows market makers to maintain tight spreads and consistent pricing of closely-related assets generally prevails, the pair also examine the “liquidity mirage”, They believe this comes about because the market participants respond to market activity as well as news about fundamentals.
“This can lead to order placement and execution in one market affecting liquidity provision across related markets almost instantly,” they wrote. “The modern market structure therefore implicitly involves a trade-off between increased price efficiency and heightened uncertainty about the overall available liquidity in the market.”
Sampling data from October 2014, including the infamous flash crash on 15 October 2014, the study found that up to 20% of Treasury futures trades at the bid /offer are associated with depth reduction at the bid/offer on the BrokerTec platform.
“This BrokerTec order book reaction to CME trades peaks at a roughly 5 millisecond delay, which matches the current shortest possible transmission time between the two venues using cutting-edge microwave transmission technology,” they wrote. “The evidence therefore supports the hypothesis that rapid depth reduction by low-latency liquidity providers contributes to the liquidity mirage. It is also worth highlighting that October 15, while exhibiting extreme price volatility, is not an outlier in this regard. As such, we did not find any evidence that the liquidity mirage was more pronounced on October 15 compared with our control days.”
Having compared what they identify as ‘prudent market-making’ with ‘pre-emptive aggressive trading’, the authors conclude that the cross-market patterns in trading and order book changes they study suggest that “quote modifications/cancellations by high-frequency market makers rather than pre-emptive aggressive trading are an important contributing factor to the liquidity mirage phenomenon.”
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