1. Every cloud has a silver lining: Fast trading, microwave connectivity and trading costs
Andriy Shkilko & Konstantin Sokolov
Wilfrid Laurier University
Central Bank Workshop on the Microstructure of Financial Markets, Paris 2016

2. Are these differentials good for liquidity?
What we do, in a nutshell
A speed race in modern markets leads to substantial speed differentials among traders
Are these differentials good for liquidity?
Our answer: No

3. Speed differentials: theory
The effect of speed differentials on market quality may be positive or negative
Positive:
Hoffmann (2014)
Jovanovic and Menkveld (2015)
Roşu (2015)
Negative:
Biais, Foucault and Moinas (2015)
Budish, Cramton and Shim (2015)
Foucault, Hombert and Roşu (2016)
Menkveld and Zoican (2016)

4. Which order types do traders use?
Informed (and, recently, fast informed) traders often use limit orders:
Hasbrouck (1991)
Griffiths, Smith, Turnbull and White (2000)
Bloomfield, O’Hara and Saar (2005) …
O’Hara (2015)
Brogaard, Hendershott and Riordan (2016)
Chordia, Green and Kottimukkalur (2016)
Liquidity suppliers try to stay on top of the latest technology to maintain a speed advantage
Brogaard, Hagströmer, Nordén and Riordan (2015)

5. Information transmission between Chicago and New York

6. The race to zero in the Chicago-New York corridor
Legacy fiber-optic cable: 7-8 milliseconds (ms)
Spread Networks cable: 6.5 ms
Microwave networks: 4.5 ms
Speed of light: 4 ms

7. Microwave networks (MWNs)

8. MWN characteristics
In , accessible by a small number of trading firms
limited number of FСС licenses
low bandwidth
Relatively easily disrupted
rain
snow

9. Fast, but not always reliable: rain fade

10. What we find When speed differentials are eliminated,
in the short run, due to precipitation
adverse selection declines
trading costs decline, in part due to the emergence of latent liquidity
volatility declines
in the long run, …
Marketable orders play an important role in futures-equities arbitrage
The results are more pronounced in assets with binding tick sizes, in which informed liquidity supply is more difficult

11. Democratization circa 2013
In early 2013, one of the technology providers begins selling futures pricing information to everyone on a subscription basis
effectively democratizing information transmission

12. What we find When speed differentials are eliminated,
in the short run, due to precipitation
adverse selection declines
trading costs decline, in part due to the emergence of latent liquidity
volatility declines
in the long run, …
Marketable orders play an important role in futures-equities arbitrage
The results are more pronounced in assets with binding tick sizes, in which informed liquidity supply is more difficult

13. What we find When speed differentials are eliminated,
in the short run, due to precipitation
adverse selection declines
trading costs decline, in part due to the emergence of latent liquidity
volatility declines
in the long run, due to technological democratization
all of the above
trading volume increases
Marketable orders play an important role in futures-equities arbitrage
The results are more pronounced in assets with binding tick sizes, in which informed liquidity supply is more difficult

14. Data and samples Sample period I: 2011-2012
Sample period II:
Millisecond trade and quote data for equities (DTAQ)
Millisecond order book data for select futures from the CME
Precipitation data from the National Oceanic and Atmospheric Administration (NOAA)
Two samples:
Small: 5 ETFs
Large: 100 ETFs

15. Precipitation along the MWN paths (www.noaa.gov)

16. Data and samples Sample period I: 2011-2012
Sample period II:
Millisecond trade and quote data for equities (DTAQ)
Millisecond order book data from the CME
Precipitation data from the National Oceanic and Atmospheric Administration (NOAA)
Two samples:
Small: 5 ETFs and corresponding futures contracts
Large: 100 ETFs

17. Price impacts Price impact are 30-40% of effective spreads
Chakrabarty et al. (2016) find a similar share for a recent sample of equities

18. Price impacts during MWN disruptions
Price impacts decline by standard deviations (or 7.05%) during significant precipitation episodes This effect is most pronounced for ETFs, in which the tick size is the most binding

19. Costs and revenues during MWN disruptions
Effective and realized spreads decline by, respectively, 7.2% and 5.3%

20. Latent liquidity
Under favourable conditions, latent liquidity may emerge
Chakrabarty et al. (2016)

21. Volatility declines by 5.8%

22. What happens on the other side of the corridor?
Hasbrouck (1995) and Westerlund, Reese and Narayan (2014) methodologies suggest that the futures market leads price discovery Consequently, asymmetric information and trading costs in futures do not change when the MWNs are disrupted

23. Event study: 2013 democratization
In early 2013, a data provider begins selling latest price information at both ends of the Chicago-New York corridor
this move effectively removes advantages of the fastest traders
consequently, we find no precipitation effects in
A quasi-DID analysis of the Quincy move shows declines in adverse selection, trading costs, market maker revenues and volatility
Notably, trade increases

24. Robustness

25. Conclusions
Liquidity providers do not always rush to adopt the latest technology and prefer to transfer increased adverse selection risk to liquidity demanders
The fastest traders do not always assume the market making role. Rather, they often take liquidity
Consistent with theory, speed differentials lead to higher
adverse selection
trading costs
volatility
Thank you

26. Trading activity and volatility
The number of trades declines by 17.8%. Expectedly, this decline is observed only in the most constrained ETFs Volatility declines by 5.8%

27. Intraday patterns

28. A weather front