Seeking to resolve the widely debated effect of flash order functionality on market quality, the authors perform two natural experiments for the period when flash functionality was introduced to the NASDAQ. One experiment consists of a 10-day event study, and the other uses a difference-in-differences analysis over the sample period April–October 2009. Using these methodologies, the authors conclude that market quality is enhanced by the presence of flash order functionality, which serves to improve market liquidity and decrease market volatility.
The authors seek to resolve the widely debated effect of flash order functionality on market quality. Flash orders are trades made at super-high speeds electronically on particular exchanges. Using several methodologies, the authors find that market quality is enhanced by the presence of flash order functionality, which serves to improve market liquidity and decrease market volatility.
How Is This Research Useful to Practitioners?
Given the public skepticism about flash order functionality, driven in part by the first flash crash (6 May 2010), this research could be a helpful resource for practitioners to use in client meetings. In the flash crash, the Dow Jones Industrial Average experienced its largest intraday drop up to that time, falling some 998.5 points within minutes. Lasting just 36 minutes, the first flash crash rattled investor confidence in flash order functionality.
Another flash crash, on 24 August 2015, which led to an even larger intraday point drop, did not help settle investors’ concerns about anything related to flash trading. With public skepticism running rampant, investment advisers and portfolio managers are faced with periodic queries from clients who question the legitimacy of the stock market and whether flash order functionality is hindering their long-term investment goals.
How Did the Authors Conduct This Research?
The authors use two primary tests to determine whether flash order functionality is a hindrance to or facilitator of market quality. The first test is a 10-day event study around the introduction of flash order functionality to the NASDAQ on 5 June 2009 and its subsequent removal on 31 August 2009. An event study evaluates the impact of a specific piece of news or event related to a company and its stock. In the other test, they use a difference-in-differences (DID) analysis over the sample period April–October 2009. A DID analysis seeks to mimic a formal experiment by studying the differential effect of a treatment on a “treatment group.”
The data used for both tests consist of the complete set of quotes and trades in the NASDAQ system for the sample period 1 April–31 October 2009. To determine the impact of flash orders on market quality, the authors use daily end-of-day data from CRSP. They use two measures of spread: quoted and relative.
The authors have produced a timely and engaging piece that is a must-read for practitioners in the investment management industry. As investment advisers have struggled to answer these questions over the past six years, many have sidestepped the question of flash order functionality by focusing on the long-term nature of their clients’ portfolios. For example, even if there were an intraday drop on the Dow in excess of 1,000 points, how much would it truly affect the portfolio returns of a long-term investor? Stock picking and asset allocation have a much more significant effect on the returns of a long-term investor than does concerning oneself with the volatility that can result from flash crashes.
Other investment advisers may focus their answers on the theoretical benefits of flash order functionality for market efficiency. Under this view, flash order functionality produces tangible benefits for the average investor.