When stock markets seized up in early May 2010 — the Dow Jones Industrial Average did a 15-minute, 1,000 point bungee jump — many were quick to point the finger at other fingers: the ones attached to ham-handed traders mistyping their sell orders.

Maybe. Or maybe it was something else.

Welcome to the new world of liquidity. Some analysts suggest that the volume of trading was edging sharply higher minutes before what has become known as the “flash crash”. Electronic high-frequency traders, getting mixed signals at the very beginning of the market downturn, withdrew from the marketplace — taking their liquidity with them.

The result: with no buyers, some stocks dropped to mere pennies.

That scenario isn’t farfetched. High-frequency traders account for up to 70% of the U.S. trading volume by some estimates — and account for an increasing proportion in Canada, too.

The specialist switch
Specialists and market-makers — those who used to process client sell orders by buying the stocks themselves, holding them until they sell them into the market — are now a diminishing breed.

And not highly regarded, according to one trading firm. Specialists earned a spread for providing liquidity that many investors resented, says Gordon Charlop, managing director at Rosenblatt Securities, a New-York-based institutional trading firm. He was speaking in Toronto last month at a summit on institutional trading technology sponsored by Radius Financial Education, an arm of Canadian Hedge Watch.

High-frequency traders, along with electronic trading platforms that have displaced the old floor brokers, have made trading more efficient and less costly for institutional and retail investors, he argues. In particular, they have added liquidity, making it easier to buy and sell. As a result, bid/ask spreads have come in. New exchanges — or regulated trading platforms — have entered the market to compete on the price for making a trade. And, with a faster order flow, there are more opportunities to arbitrage pricing differences across various marketplaces — stock exchanges, electronic communications networks in the U.S., alternative trading systems in Canada, and multi-lateral trading facilities in Europe.

But some aren’t convinced of the high-frequency benefits. One reason: many traders are not so much providing liquidity as earning profits for setting up bids — as passive liquidity providers, they get rebates from the exchanges (who in turn, profit from commissions on the volume of orders).

“Often, there’s nobody on the other side when you want to trade,” says Vidis Vaisiunas, head of trading at Highstreet Asset Management in London, Ontario. The rebate takers, he argues, “were getting in the way of the investors.”

As a result, trading commissions may have come down, and bid-ask spreads may have tightened, but those savings are washed out by market impact costs — the leakage of information about potential buys and sells by large investors to the market, who promptly pounce on signs of buying or selling activity.

More importantly, during the “flash crash,” Vaisiunas says, “the liquidity wasn’t there.”

And with fluctuating liquidity, he warns of getting “pennied” on each trade: the bid-ask spread is a penny more than it should be, which adds up on large trade sizes of, say 100,000 shares.

Volume vs. liquidity
But Bruce Boytim, vice-president of managed transactions at NYSE Euronext, suggests that getting “pennied” isn’t so bad — at least for retail investors. What they’re concerned about is commissions — the cost to transact a trade. A penny on the bid-ask spread won’t make much of a difference to them.

Vaisinuas agrees that commissions are important — although retail commissions are much higher than institutional commissions for trading. But lower commissions, thanks to higher trading volume fostered by electronic trading are not going to redound to client’s advantage if executing brokerages have to spend tens of millions of dollars to upgrade their trading engines. What’s more, those electronic trading engines at the brokerages could trade against clients — by automatically putting up momentary bids and offers and shutting down when the algorithms say so — as they appeared to do in the “flash crash.”

The high-frequency traders get paid for order flow. But so do retail U.S. brokerages, such as Charles Schwab, who sell their order flow to other brokers. Buying order flow is not allowed in Canada.

So it comes down to volume versus liquidity. High-frequency trading increases volume — the bids and offers are pinged constantly, and in milli-, micro- and nanoseconds. But is there more liquidity — the ability to the trade shares at an acceptable price? Vaisinuas says there isn’t.

Charlop warns, however, the alternative is simply for brokerages to revert to past practice and internalize their order flow — to match buy and sell orders from inventory.

Which is what launched electronic trading in the first place: to create a more liquid and transparent market.