Executive Summary: We examine the conditions, complexities and risks of a fragmented market microstructure to contextualize the role of algorithmic and high frequency trading in the US equity markets. The establishment of a national market system and Regulation NMS was meant to promote competition, recognizing the evolution and changing dynamics introduced by technological innovation. This evolution and governing rule set has had many positive effects in terms of competition, fee compression, tighter spread potential and volumes. Our paper identifies certain unintended consequences and complexities of the national market system including fragmentation, sub second quoting and trading, complex order types, data asymmetry, technological innovation, unique strategies and the algorithms that power them. When acting in concert, these complexities give rise to opportunities as well as emerging risks.

This high-speed system can be unstable and susceptible to inherent conflicts of interest, market abuse and price shocks. These shocks can be amplified by positive feedback loops accelerating single stock declines and also posing systemic risks in time scales beyond real-time physical human comprehension and reaction times. Furthermore they can produce contagion, which we refer to as ‘Flash Splashes’ caused by rapid withdrawals and injections of liquidity in increasingly linked asset classes, indices, sectors and global liquidity pools. High frequency trading strategies can be both passive and aggressive and usually display risk averse and low inventory characteristics. These strategies leverage fragmentation as they create or capture informational asymmetries. They interact directly with sell side algorithms that can hide intentions, hunt liquidity and sweep the order book. These interactions create market dynamics that can benefit and challenge anyone exposed to US equity markets.

Every market participant has a risk profile unique to their strategy and objective and while regulations will be enriched or revised and certain unfair practices eliminated great attention should be paid to understanding modern high speed trading risks and both the positive and negative impacts on all stakeholders. We have examined the regulations, complexities and risks to bring clarity and understanding to the current trading ecosystem for its users.

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