Almost twenty years of stock data suggests that innovations in stock trading that have decreased spreads between bid and ask prices have come alongside increased volatility, raising questions about whether the smaller spreads are saving investors money.
The study comes from the capital markets arm of Royal Bank of Canada, which looked at stock ticks for more than 400 stocks since 1996.
In that time, the spread between buy and sell prices has steadily shrunk. First, in mid-1996, trading increments went from 1/8 of a dollar to a nickel. Then came "decimalization," which opened the possibility of spreads coming down to pennies. At the same time, trading venues proliferated, as did new pricing methods that led exchanges to offer rebates to traders.
All of that is generally credited with spurring the explosion of electronic-based trading companies known as high frequency traders, who try to exploit differences between markets to capture inefficiencies and rebates.
There is absolutely no doubt that spreads have shrunk in the study period. The difference between the bid and ask price was as much as 70 basis points in 1996. Since 2010, it has hovered below 10 basis points.
And by some measures, volatility is waning. Stories of the somnolent VIX index, which is supposed to measure broad U.S. stock market volatility, are easy to find.
But RBC, a bank that has been a long-time critic of HFT strategies, suggests that is not the whole story. Individual stocks in Canada are more volatile from moment to moment. And that, RBC said, may offset any benefit from smaller spreads by making it harder for traders to get a handle on where stocks are going and trade effectively.
"Supporters of the aforementioned changes cite increased volume traded and narrower spreads as irrefutable evidence of how our market structure has improved," the study's authors wrote. "Many also claim that today's markets have reduced volatility by absorbing short-term supply/demand imbalances. But is this claim really valid?"
RBC's explorations of the data do show an increase in volatility by some measures.
The firm looked at windows of trading during the day for the stocks, and found that "relative to its daily trading range, the median stock in our sample has experienced a 70 to 100 per cent increase in intraday price range volatility, nearly double pre-2000 levels." Looking at 5 minute, 10 minute and 15 minute windows, the range between the highs and lows in stocks even in those short intervals has been steadily increasing.
The firm looked at it another way, using the volume weighted average price (VWAP) for stocks. VWAP is a pretty standard measure when traders are trying to determine whether they got a good price – how far away was their average price from the VWAP in the period in which they were buying or selling.
Looking at deviation from short-term VWAP in similar windows of time, stocks are steadily swinging more widely away from VWAP. "For the median stock in our study the increase in price deviation relative to VWAP ranged from 80 to 200 per cent, more than double pre-2000 levels."
It's not just the median stock. The number of stocks that swing widely in the sample set is also increasing.
RBC's view is that the data show "that intraday trading volatility relative to daily volatility has approximately doubled from pre-2000 levels," and that volatility is the "new spread" and a "substantial hidden cost for natural investors." (Natural investors is a term sometimes used for people who are buying and selling for long term plans, as opposed to flippers.)
"In today's environment, any desire to transact in sizes much larger than a board lot and/or over time can result in a rapid decay of benefits realized from narrower nominal spreads."
So what to do about it?
RBC suggests three things. One, investors have to fight back, understanding the issue. Two, look again at whether some of the ways exchanges lure traders, such as the maker-taker rebate model, are helping or hurting. (The Ontario Securities Commission is looking at maker-taker.) And third, "reign in 'innovations' lacking clear benefits." This requires regulators to take a more activist stance on approving or blocking new types of orders, trading engines, and other changes.