Fast traders and slow price adjustments: an artificial market with strategic interaction and transaction costs

Abstract

In this paper, we propose an artificial market to model high-frequency trading where fast traders use threshold rules strategically to issue orders based on a signal reflecting the level of stochastic liquidity prevailing on the market. A market maker is in charge of adjusting prices (on a fast scale) and of setting closing prices and transaction costs on a daily basis, controlling for the volatility of returns and market activity. We first show that a baseline version of the model with no frictions is able to generate returns endowed with several stylized facts. This achievement suggests that the two time scales used in the model are one (possibly novel) way to obtain realistic market outcomes and that high-frequency trading can amplify liquidity shocks. We then explore whether transaction costs can be used to control excess volatility and improve market quality. While properly implemented taxation schemes may help in reducing volatility, care is needed to avoid excessively curbing activity in the market and intensifying the occurrence of abnormal peaks in returns. Response to Reviewers: Dear Editor, we submit a deeply revised version of our work and thank you for the request to polish once more the text. We decided to use a professional editor and we have indeed fixed many typos and improved the language in (literally) dozens of places. We truly believe the paper is now more readable and clearer. Do not hesitate to contact us if any further action is needed. Best regards,