The Causal Impact of Algorithmic Trading on

Market Quality : A Summary

Rishabh Shukla
Policy makers, worldwide, are exploring ways of curbing the use of Algorithmic
Trading (AT), which is allegedly used for market manipulation (layering and
spoofing, momentum ignition etc.) in general and is deemed to be responsible
for flash crashes that are brief periods of extremely high volatility.
The paper by Nidhi Aggarwal and Susan Thomas (2014) aims to analyse the
impact of AT on market quality (of which quoted market depth and spreads are
indicators) in electronic limit order book markets to test the hypothesis that
AT adversely affects market quality and that AT leads to higher incidence of
flash crashes (of which kurtosis of security returns is an indicator).
The paper uses the NSE dataset which accounts for 75% of equity spot trading
and 100% of derivatives trading in the country during the period of analysis,and includes every security traded on NSE in the analysis window. Thus
market quality can be analysed at the level of the overall financial system and
problems related to fragmented trading can be mitigated, unlike in advanced
countries. To address the endogeneity issue (since unobserved factors can affect
market quality and AT at the same time), the paper exploits the exogenous
event of introduction of co-location facilities ( resulting in reduced latency and
increased bandwidth leading to higher use of AT) which were made available at
NSE, which directly affected the level of AT but not the market quality.
The experimental design adopted identifies pairs of securities using the propensity score matching algorithm; which are otherwise identical in characteristics (
found using observable covariates) but differ in the level of AT. The securities
which undergo a large change in AT activity after co-lo are referred to as the
treated group and those which do not show significant change in the level of
AT after co-lo (but were similar to the treated group before co-lo) are referred
to as the control group.In order to control for unobserved factors like changes
in macroeconomic conditions, periods with similar level of market volatility are
chosen in the pre and post co-lo regime.
A difference-in-differences (DiD) regression is used to estimate the effect of AT
(the treatment) on the market quality (the outcome). Market Quality indicators
like transaction costs, market depth, market risk, efficiency and kurtosis are used
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as dependent variables for a given security i at time t. The coefficient(3 ) of

the interaction term ATi co lot provides the estimate of the treatment effect,
which stands for greater AT intensity in the post co-lo period. A significant value
of 3 implies that AT has an impact on the market quality.Since a decrease in
transaction costs and market risk, and an increase in depth, increases the market quality; the hypothesised value for 3 is zero. The alternative hypothesis
then being 3 < 0 and 3 > 0 respectively for transactions costs/market risk
and market depth.
The coefficients for QSpread and Impact Cost (Transaction Costs Indicators)
are found to be negative and significant implying that higher level of AT significantly reduces transaction costs. In case of market depth indicators, the coefficient is positive and significant, implying that higher AT intensity increases
shares available for trade in the market.
The hypothesis for efficiency measures like variance ratio and kurtosis is that
3 = 0 with the alternative hypothesis being that 3 < 0. If AT intensity does
improve price efficiency, we expect |V R1| and kurtosis to be close to zero. The
kurtosis coefficient estimate turns out to be positive and insignificant implying
greater probability of extreme price movements intra-day due to AT. For every
security i, frequency of price movements greater than a threshold price relative
to last days trading price is tested. The coefficient is negative and significant
only at the 5% threshold and insignificant at 2% and 10%, implying that higher
AT intensity either reduces the probability of extreme price movements or is
the same as for low AT intensity securities.
In order to verify the robustness of the results that the experimental design
yields, a placebo is simulated in which a subset of the treatment group is taken,
which is unaffected by the intervention i.e. has a low level of AT activity and
is matched with low level AT activity securities before intervention. The DiD
estimates for such a treatment and control group should not be significantly different from zero. This hypothesis is rejected less than 5% of the time implying
that a change in the market quality does not take place without a change in
the level of AT intensity. Thus the experimental design does not suffer from the
placebo effect.
The sensitivity to match design is tested by dropping each of the selected covariates one at a time to yield a new dataset to run the DiD regression on. The
estimated 3 coefficients are analysed for change in sign due to the modification
of the matching co-variates implying a change in the impact of market quality
due to the level of AT. The estimates for few Depth parameters and Kurtosis
do change implying weakly established causality for these indicators.
The paper concludes that higher AT intensity reduces intra-day liquidity for securities and leads to either fewer flash crashes or has no effect at all. Thus there
are more benefits than costs to securities that attract higher level of AT activity.
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