US Equity Market Structure: Trading the Dead Zone

Regulatory changes coupled with evolution of electronic trading have not only transformed the liquidity landscape in terms of market participants and trading venues, but also the timing of available liquidity. Since 2007, there has been a shift in the overall industry volume to the opening and closing, although the impact has been much more significant for small-cap stocks.The intraday liquidity for small-cap stocks has become similar to spotty cell phone service; there are sporadic bursts of liquidity and dead zones with barely any liquidity (cell reception) at all. Stocks with lower trading volumes face an even greater challenge in sourcing liquidity without leaving a large footprint and risking information leakage. Market participants need innovative maneuvers and customized tools to navigate liquidity dead zones.

One-size-fits-all trading solutions are no longer viable options in today’s complex market structure with 50+ trading venues. Traders and algorithms require specific attributes in order to optimize execution quality. A vital component of the evaluation is formulating customized metrics, which segregate and weigh a trade’s macroeconomic strategy/urgency versus the algorithm liquidity sourcing and market impact performance.

The unpredictability of the liquidity intraday along with gaming potential has some market participants and the Congress questioning whether reversing the minimum quote size increment implemented in 2001 could lead to additional liquidity and less volatility in small-cap stocks. As with any empirical study, identification of the question being answered and common interpretation of results become paramount to its success.

In the meantime, market participants need to be highly cognizant of stock level liquidity trends in the algo selection process. It is also important to consider an algo provider’s reliability, distribution and compatibility with your existing workflow. And last, but not least, customized metric formulation and review will enable firms to fine tune and optimize execution quality along with the changes in the market structure.