Why investors should be wary of liquidity pools

Onus on the individual to educate themselves about market structure pitfalls

Why investors should be wary of liquidity pools

While markets are – or should be – more attune to risk after the pain of 2008, a leading trader has warned investors of the dangers of disconnected liquidity pools.

The onus is on the retail investor, said John Christofilos, senior vice-president and chief trading officer at AGF Investments Inc, to educate themselves about market structure so they know where their order is going and how it is being executed.

He added that multiple liquidity pools that don’t talk to each other mean price differentials and more feverish high-frequency trading. This, in turn, increases the likelihood of a flash crash, meaning it’s vital an investor has a broker who understands what is going on in the market.

Christofolis said exchange circuit-breakers offer reassurances but that should not stop the investor doing their homework so they know what they are putting their money into.

He said: “The danger of liquidity pools is you get a dislocation of prices – so one liquidity pool may have a price at $10 while another may have a price of $9.98. It doesn’t sound like a lot but every penny counts.

“If you are doing this multiple times, and you are an active trader, you are losing out on every single trade because of the way your executing broker is routing the trade means you are giving away money to somebody.

“Typically, that person on the other side is a high-frequency trader or a robot. So it’s important to understand the market structure and to make sure the broker that you’re using to execute those trades, or the asset manager that you are relying on, fully understands what’s going on.”

Christofolis said there remains a degree of the unknown around flash crashes like the one investors experienced in February because of the activity and volume around the ETF market and the prospect of more volatility.

But he said it’s simple: the more liquidity pools out there, the higher the probability that something could break in the system that could cause the next flash crash.

To protect themselves, apart from making sure they are educated in market structure, investors should look for over-reactions on the downside.

Christofolis said: “They have typically been a terrific buying opportunity. The unfortunate thing is when there is a massive downdraft, people get scared and they don’t react, they actually freeze.”


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