While increasing electronification of markets has brought many benefits to market participants, some have expressed concern about the speed and automation of electronic trading, including rapidly changing price quotations and order cancellations, according to Citadel Securities.
In its latest white paper, “Market Lens: Why Restricting Cancel Rates Can Increase Bid-Ask Spreads”, Citadel examines how order cancellations fit into modern markets and how various factors have contributed to the rise of – and benefits from – this activity.
According to Citadel, rather than being indicative of any problems, healthy quote cancellation rates have become not only normal, but also integral to the proper functioning of modern markets, resulting in greater efficiency, narrower bid-ask spreads, and more robust price discovery.
The new paper is a follow up from last year’s article “Why Do Electronic Traders Cancel Orders? What ever-increasing speeds for issuing and cancelling orders tell us about today’s market structure”.
According to the paper, information now changes faster than ever before and competition among automated traders to offer better pricing has become more vigorous.
In the face of these developments, order cancellations allow automated traders to dynamically adjust their prices to reflect rapid changes in supply and demand, which results in tighter bid-ask spreads and better execution for all market participants.
Several features of modern trading and markets cause high levels of order cancellations as a normal and beneficial course of business.
A common characteristic across today’s markets is the use of computers to calculate desired prices — as well as to route, execute and communicate the status of orders — with far greater speed, scale, transparency, and efficiency than was possible in manual markets, the paper said.
According to the findings, a market that artificially limits cancellations also artificially widens tick sizes in the process: “These wider tick sizes increase transaction costs for investors and impair liquidity.”
“All else equal, when bid-ask spreads widen or narrow, cancellation and message rates move in the opposite direction.”
Two examples are seen in the U.S.’ “Tick Size Pilot” and stocks that change between below and above $1, according to the white paper.
These examples are particularly illustrative, Citadel said, because, in the first, the pilot provided an ideal test and control setup to see the effects of a change in spreads where the comparison between the test and control groups should eliminate other potential factors.
In the second, the “SubPenny Rule” in the U.S. constrains any stocks priced above $1 to a minimum spread of $0.01 while those priced below $1 can have a spread as small as one one-hundredth of that size.
“This means that the spreads for any stocks that are tick constrained when barely above $1 and which move below $1 can collapse only due to that price change,” Citadel said.
These examples illustrate the point that cancel rates and spreads are two sides to the same coin.
“When market makers have the opportunity to compete more aggressively they do so.”
“Tighter spreads inherently drive higher cancellation rates, but the value created in the form of lower bid-ask spreads, better price discovery, and ultimately a lower cost of capital for issuers are a huge benefit to both investors and the broader economy.”
