SOES trading and market volatility

The National Association of Security Dealers alleges that professional-trader use of the Small Order Execution System (SOES) causes greater security price volatility, We document bidirectional Granger causality between a proxy for professional SOES trading (the frequency of maximum-sized SOES trades) and a measure of stock price volatility. We find that high levels of volatility precede high levels of maximum-sized SOES trades, suggesting that volatility causes more frequent large SOES trades. Likewise, over a one-minute time interval, high levels of maximum-sized SOES trades cause high volatility. Over longer periods, however, intense maximum-sized SOES trading causes lower volatility. Interpreted in conjunction with Harris and Schultz (1997), these results suggest that high levels of maximum-sized SOES trades lead to more efficient price discovery. In light of these results, we believe that efforts to eliminate SOES based on volatility considerations are unwarranted.