Vanderbilt Study: High-Frequency '€œPhantom Liquidity' Is Not Hurting Retail Traders

A new study by Vanderbilt University Assistant Professor Jesse Blocher has seemingly debunked the myth that high-frequency traders (HFTs) are systematically setting pricing traps to lure retail traders.

HFTs are the primary topic of Michael Lewis’ best-selling book “Flash Boys,” in which Lewis describes how HFTs place and then immediately cancel orders so that prices seem to change unfavorably for retail investors between the time they place their order and the time their order is executed.

Critics of HFTs say that they systematically place and then immediately cancel millions of orders to create what’s known as “phantom liquidity” and give the illusion of supply and demand in the market to move prices to their advantage.

Blocher’s new study finds little evidence of this practice.

Blocher looked at 5.78 terrabytes of message activity on S&P 500 stocks from 2012 and found that HFTs weren’t impacting retail execution prices.

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The researchers found that HTFs are responsible for a number of short bursts of order cancellations throughout the trading day, which Blocher calls “cancel clusters.”

The Vanderbilt study included three main findings related to these cancel clusters:

• Cancel clusters typically only last around 5.68 seconds each and occur throughout only 6.7 percent of the trading day.
• Few trade executions actually take place during cancel clusters, suggesting that they are not used to lure retail traders.
• Most trading executions, and therefore price movements, take place outside of cancel clusters.

So, what’s the point of these cancel clusters?

“Cancel clusters are a lower-cost means of price discovery,” Blocher suggested. In other words, these clusters are a way for HFTs to test the market to determine the most accurate price of an asset.

As it turns out, HFT cancellation clusters may actually benefit retail traders by providing greater market stability and efficiency.

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