Recent bouts of volatility in the US equity market were not caused by technology-driven market makers, according to a thorough examination of depth-of-book data carried out by Citadel Securities.
The US-based liquidity provider published an analysis of aggregate order book data from direct data feeds of US exchange groups, revealing that several episodes of heightened volatility in the US equity market witnessed over the past 12 months had nothing to do with quantitative investment strategies and computer-driven trading activities.
Market participants and observers often point to changes in market structure, regulation, or the rise of electronic market makers, as factors behind periods of rapid stock price drops or diminished market liquidity.
“Given that the fundamental forces that have positively reshaped our equity markets have been at work for more than a decade, it seems unlikely that they are responsible for either impaired market liquidity or by extension, the episodes of volatility seen over the past year,” Citadel Securities stated.
Citadel Securities described today’s market as “incredibly competitive”, with a new generation of technologically-sophisticated market participants having emerged as the “dominant liquidity providers”. Those participants have displaced legacy dealers, including large banks, that have been slow to compete in more automated markets.
“This new competitive landscape has been in place for the better part of the last decade, which again makes it an implausible cause of recent market swings,” Citadel Securities said. “To the extent banks today face constraints in conducting certain trading activities, it is difficult to see how that explains stock market volatility, given the negligible role banks have played as liquidity providers in these markets for over a decade.”
The study claimed that liquidity in US equity markets over the past eight years has, in fact, been “remarkably stable”, and the resilience of the market during the global financial crisis “compares favourably to bank-intermediated over-the-counter markets”, such as certain derivatives markets which suffered during that period.
An in-depth look at liquid stocks including Microsoft, Apple, and Google, found that the cost of executing large-sized trades has remained relatively constant, but spreads have decreased for medium and small-sized trades, contributing to the idea that liquidity has diminished.
Although this perception, which Citadel Securities labelled as flawed, is often derived from analysis of displayed size at the national best bid and offer, rather than full depth of displayed liquidity on US exchanges.
“Our size-adjusted spread measurement for a $1 million S&P 500 transaction, for example, has hovered at approximately two to four basis points (bps) for virtually all of the eight-year period measured. Similar patterns hold for $10 million (3-6 bps) and $100 million trades (9-24 bps) in this broad-market benchmark,” Citadel Securities’ analysis claimed.
“While recent and past decreases in liquidity depth (aka increases in size-adjusted spreads) have coincided with spikes in the VIX, this has not exclusively been the case and the data does not suggest that the depth or resiliency of liquidity is fundamentally different today than it has been over the past eight years.”