UK equity market microstructure in the age of machine
Financial markets perform two major functions. The first is the provision of liquidity in order to facilitate direct investment, hedging and diversification; the second is to ensure the efficient price discovery required in order to direct resources to where they can be best utilised within an economy. How well financial markets perform these functions is critical to the financial welfare of every individual in modern economies. As an example, retirement savings across the world are mostly invested in capital markets. Hence, the functioning of financial markets is linked to the standard of living of individuals. Technological advancements and new market regulations have in recent times significantly impacted how financial markets function, with no period in history having witnessed a more rapid pace of change than the last decade. Financial markets have become very complex, with most of the order execution now done by computer algorithms. New high-tech trading venues, such as dark pools, also now play outsized roles in financial markets. A lot of the impacts of these developments are poorly understood. In the EU particularly, the introduction of the Markets in Financial Instruments Directive (MiFID) and advancements in technology have combined to unleash a dramatic transformation of European capital markets. In order to better understand the role of high-tech trading venues in the modern financial markets’ trading environment generally and in the UK in particular, I conduct three studies investigating questions linked to the three major developments in financial markets over the past decade; these are algorithmic/high-frequency trading, market fragmentation and dark trading. In the first study, I examine the changing relationship between the price impact of block trades and informed trading, by considering this phenomenon within a high-frequency trading environment on intraday and inter-day bases. I find that the price impact of block trades is stronger during the first hour of trading; this is consistent with the hypothesis that information accumulates overnight during non-trading hours. Furthermore, private information is gradually incorporated into prices despite heightened trading frequency. Evidence suggests that informed traders exploit superior information across trading days, and stocks with lower transparency exhibit stronger information diffusion effects when traded in blocks, thus informed block trading facilitates price discovery. The second study exploits the regulatory differences between the US and the EU to examine the impact of market fragmentation on dimensions of market quality. Unlike the US’s Regulation National Market System, the EU’s MiFID does not impose a formal exchange trading linkage or guarantee a best execution price. This has raised concerns about consolidated market quality in increasingly fragmented European markets. The second study therefore investigates the impact of visible trading fragmentation on the quality of the London equity market and find a quadratic relationship between fragmentation and adverse selection costs. At low levels of fragmentation, order flow competition reduces adverse selection costs, improves market transparency and enhances market efficiency by reducing arbitrage opportunities. However, high levels of fragmentation increase adverse selection costs. The final study compares the impact of lit and dark venues’ liquidity on market liquidity. I find that compared with lit venues, dark venues proportionally contribute more liquidity to the aggregate market. This is because dark pools facilitate trades that otherwise might not easily have occurred in lit venues when the spread widens and the limit order queue builds up. I also find that informed and algorithmic trading hinder liquidity creation in lit and dark venues, while evidence also suggests that stocks exhibiting low levels of informed trading across the aggregate market drive dark venues’ liquidity contribution.
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