High-frequency trading and networked markets

Financial markets have undergone a deep reorganization during the last 20 y. A mixture of technological innovation and regulatory constraints has promoted the diffusion of market fragmentation and high-frequency trading. The new stock market has changed the traditional ecology of market participants and market professionals, and financial markets have evolved into complex sociotechnical institutions characterized by a great heterogeneity in the time scales of market members’ interactions that cover more than eight orders of magnitude. We analyze three different datasets for two highly studied market venues recorded in 2004 to 2006, 2010 to 2011, and 2018. Using methods of complex network theory, we show that transactions between specific couples of market members are systematically and persistently overexpressed or underexpressed. Contemporary stock markets are therefore networked markets where liquidity provision of market members has statistically detectable preferences or avoidances with respect to some market members over time with a degree of persistence that can cover several months. We show a sizable increase in both the number and persistence of networked relationships between market members in most recent years and how technological and regulatory innovations affect the networked nature of the markets. Our study also shows that the portfolio of strategic trading decisions of high-frequency traders has evolved over the years, adding to the liquidity provision other market activities that consume market liquidity.

The last 20 y have seen deep changes in the way financial markets operate (1). The adoption of the regulation about the national market system (“NMS”) for equity securities (2) from the Securities and Exchange Commission of the United States and a similar adoption subsequently taken by the European Securities and Market Authority have affected the structure and practice of trading of equity securities in US, European, and several other markets worldwide. The most evident change has been the proliferation of market venues in a given country or in a group of countries, usually addressed as fragmentation of markets. A related change has been the specialization of a number of market participants in high-frequency traders (HFTs). HFTs are professional traders able to use high speed in the generation, routing, and execution of orders (3). The amount of transactions performed by HFTs is today estimated to be around 50% in most markets (4). Typical response time of these traders to a market state or information can be as fast as a few microseconds. This exceptional time performance is often achieved by colocating technical infrastructures of HFTs near the computer infrastructure of large market venues. The influence of regulatory changes and technological innovations have changed financial markets into complex sociotechnical institutions (5–9).There is no shared view about how changes occurring in markets have modified the basis of financial asset trading. One view is that the presence of HFTs makes markets more efficient by decreasing the transaction cost per unit of transaction and by facilitating price discovery (10–13). Another view is that HFTs provide liquidity only under normal market conditions whereas their trading is not guaranteed in exceptional market states, making the markets more fragile and prone to flash or microflash crashes (14). There is also empirical evidence that HFTs competition is deteriorating liquidity provision (15) and that the interaction of HFTs with orders of large institutions is performed in a strategic way (16).The technical and regulatory changes observed in markets in the last 20 y are not minor but rather they deeply affect the strategic behavior of market participants (5). An example of this huge impact concerns market making and liquidity provision. Market making is the trading activity providing liquidity to the market (i.e., the trading activity allowing one to find quickly a counterpart for a transaction in a market). In the past market making was done by institutionalized figures (called specialists at the New York Stock Exchange and jobbers at the London Stock Exchange [LSE]) that paid fees to the market and had privileges and obligations for their role. Today, in most settings, market making is not institutionalized and it is freely strategically performed by specialized market participants. Technical innovations (e.g., the use of computer algorithms and the fast access and process of market quotes) and regulatory changes (e.g., market fragmentation and changes in the information production and dissemination) provide a changing environment deeply affecting the profile and ecology of different classes of investors and the way they perform their strategic choices. We believe this extraordinary transition into a changing financial market setting is a clear case study of evolution and adaptation of the ecology of market participants to new states of the financial world (17–19).Recently the empirical characterization of the trading decisions of investors (20) has made it possible to detect an ecology of investors (21, 22). In the present study, we analyze two different venues of stock markets in three different periods of time at the level of market members, i.e., at the level of those companies that are acting for their proprietary trading or are acting as brokers or dealers for the trading of customers. Our aim is to investigate whether the liquidity provision of the most active market members (notably the HFTs) presents a networked structure (i.e., it is provided under a framework of strategic decisions). With the term “networked structure” we mean that market members trading in a venue of a fragmented market in the presence of HFTs might establish statistically validated preferential or avoided trading relationships with specific market members. By using tools of complex networks (23), we detect a networked structure among market members and we document that this networked structure has evolved over the past 20 y from a poor and dynamically changing to a richer and dynamically more persistent network structure highlighting an ever-increasing strategic provision of liquidity.Financial transactions occurring in financial markets can be described in terms of trading networks (23). Examples are trading networks occurring in the Interbank market (24) and in equity markets (25). Specifically, we investigate the degree and persistence of pairwise trading relations between market members of two European stock market venues in 2004 to 2006, 2010 to 2011, and 2018. The first one is the electronic order book of the LSE during the time period 2004 to 2006 and the second one is the Stockholm venue of the Nasdaq OMX market during the years 2010 to 2011 and 2018. Nasdaq OMX is a subsidiary of Nasdaq, Inc. operating in European Nordic countries. The first set of data refers to a period when the high-frequency trading practice and its infrastructures were still developing and HFTs were expanding their share of trading. During those years, market fragmentation was still pretty limited due to the fact that the regulation about the competition between market venues was not yet issued by the European Securities and Market Authority. Market fragmentation and the diffusion of high-frequency trading expands in Europe starting from 2009 (15, 26) and the presence of market members performing HFTs became widespread in European financial markets at the same time. Since 2010, the Nasdaq OMX has provided to its market members the same technology used in the main US Nasdaq venue, including INET platform and colocation services, ensuring HFTs access to the order book within microseconds or less. Therefore, our three sets of data cover one period when the practice, regulatory framework, and technology of HFTs were still developing and two periods characterized by key regulatory and technical changes.Our analysis and statistical characterization of trading networks show that financial markets have continuously evolved into ever more complex sociotechnical systems (5–9) with a persistent networked structure which is present in the interaction of the different types of market members, making the liquidity provision a sophisticated strategic activity. In other words, since the first decade of this century markets have changed deeply and the ecological profile of market members has experienced a profound mutation. With our results we show that network-based studies are able to characterize the ecological fingerprint of some market members acting in this highly competitive sociotechnical system.