How Limit Orders and Market Orders Relate to Liquidity in HFT
Summary
The document examines the claim that high-frequency trading increases liquidity and argues that the HFT label covers participants with different trading behaviors. A participant who posts a resting limit order supplies executable interest to the order book, while a participant who crosses the spread consumes that displayed liquidity. Passive traders may cancel orders when prices are likely to move, because leaving them exposed can lead to adverse selection. After an adverse fill, they may also trade aggressively to reduce risk.
The response notes that these behaviors occur among both high-frequency firms and other market participants. It also describes the dispute over whether rapidly canceled passive quotes provide useful, accessible liquidity, and presents an alternative view that aggressive trades facilitate matching. The discussion is conceptual and does not provide measurements or settle how liquidity quality should be assessed. Its framing distinguishes the mechanics of supplying and demanding liquidity from the broader contested question of whether a particular trading style improves market quality.
Key ideas
- Resting limit orders add executable interest to an order book.
- Orders that cross the spread consume resting liquidity and enable trades to occur.
- Passive traders may cancel quotes to limit exposure to adverse price moves and selection.
- High-frequency trading includes both passive liquidity providers and aggressive liquidity takers.
- Whether frequent quoting improves liquidity quality remains contested in the document.
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Full text
# How could HFT help increase liquidity? # How could HFT help increase liquidity? I have ready in several websites that HFT can help increase market liquidity, although this is contested in some articles. I am not familiar with the concept of market liquidity. What is the basis of the argument that HFT can help increase liquidity? ## Answer by Louis Marascio (score 5, accepted) https://quant.stackexchange.com/a/9261 You can find a varying number of practitioners and academics on both sides of this debate. To be honest, the question of whether "High Frequency Traders" increase liquidity is ill-posed. The label is often misused and is broadly encompasing of too many different types of traders. So, in general: - Any trader that posts resting limit orders is adding liquidity to the market place. - Any limit order resting on the order book is immediately executable by any trader with sufficient liquidity demands. - Passive traders attempt to limit when they trade by canceling their resting orders when they believe a change in price is probably. Not doing so exposes their orders to adverse selection. - When a passive trader's orders are filled, especially when adversely selected, they sometimes, depending on their specific circumstances, have to immediately demand liquidity from the market place to reduce or limit their risk. The above applies to all participants, whether they are "high frequency" or not. You can find firms that are primarily aggressive takers of liquidity. You can also find firms that are primarily passive traders posting limit orders. This is true of "HFT" firms all the way to individual traders. Many detractors believe that passive HFTs do not add high quality liquidity to the market place. They point to high cancel/fill rates and other characteristics of their order flow as evidence. In my mind this represents a type of "model bigotry". These traders are simply better than many other participants and are using more sophisticated models. Without official market maker obligations a HFT, indeed ANY trader, should be free to manage their orders in whichever way they wish. If it means their liquidity is too hard for you to access, then you as a counter party must either choose not to trade with them or become better. I'll also add, some people even go so far as to suggest that aggressive traders also add liquidity to the market place. After all, limit orders won't be matched unless someone is willing to cross the spread and demand liquidity. This is a point of view that likely differs significantly from the academic viewpoint of liquidity. I first heard it from Jaffray Woodriff of QIM fame, and have come to believe it to be true. So, to answer your question directly, what is the basis for the argument that a "high frequency trader" increases liquidity? I'll provide two answers: - Any trader, whether a HFT or not, that posts orders is adding liquidity. - Any trader, whether a HFT or not, that takes liquidity is "adding liquidity" to the market place by trading with a resting limit order.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.