Failure to Address Lack of Liquidity a ‘Problem’ for Small Caps, U.K. HFT Study Told

Terry Flanagan

A recent U.K. study into high-frequency trading has been criticized for failing to address the issue of a lack of liquidity in small and mid cap stocks in Europe.

The much-anticipated Foresight Project, a two-year study commissioned by the U.K. government that gathered evidence from 150 academics and experts from 20 countries, barely touched upon the perceived problem despite some market users claiming that small and mid cap stocks are the future “growth engine of most of Europe”.

The study, which was published on October 23, stated that “liquidity is a fundamental property of a well functioning market, and lack of liquidity is generally at the heart of many financial crises and disasters”. It went on to say that “there has been little improvement in the liquidity of small cap stock” despite concluding that computer-based trading, “despite some very adverse macroeconomic circumstances”, has “improved” liquidity over the past decade.

“Sadly, the report seems to have researched the impact of computer trading in large capitalization stocks trading on equity markets,” said Professor Brian Scott-Quinn, non-executive chairman of the ICMA Centre, a business school for financial markets, at the University of Reading.

“These are the stocks which may not need any additional liquidity of the type provided by high-frequency traders. The real societal problem is that we have not yet found any mechanisms to provide adequate liquidity in small and medium sized enterprise bonds and shares. The report remains silent on such issues.”

High-frequency traders are more prevalent in highly liquid large cap stocks as the small cap arena is generally more unattractive to HFT because the lower trading volumes do not support rapid-fire trading as well.

“HFT only operate in large cap,” Kee-Meng Tan, managing director and head of agency broker Knight Capital’s trading group in Europe, told Markets Media’s recent European Trading Investing Summit in London on October 11.

“As a consequence there is a significant lack of liquidity in the small and mid cap space and those are the companies that are going to be the growth engine of most of Europe. These guys can’t get anything traded on their stocks.”

Earlier this year, Knight expanded its market making operations in London to include a small and mid cap European equities desk in a bid to increase liquidity in the space.

Tan, though, believes that HFT cannot seem to win in the eyes of some market participants, especially if there is a concerted push in the future by HFTs to enter the European small and mid cap space.

“Look at the U.S. ‘flash crash’ [in 2010]—people talk about how all of the HFT disappeared from the market and hence there was no liquidity,” he said.

“But on the flip side people say they want to get rid of these guys as they are messing around with the market. So what is it exactly? Do they want them in or out? When they are out you can’t blame them but when they are in there is an issue.”

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