Where is the Value in High Frequency Trading?

Abstract

We analyze the impact of high frequency trading in financial markets based on a model with three types of traders: liquidity traders, market makers, and high frequency traders.Our four main findings are: i) The price impact of the liquidity trades is higher in the presence of the high frequency trader and is increasing with the size of the trade. In particular, we show that the high frequency trader reduces (increases) the prices that liquidity traders receive when selling (buying) their equity holdings. ii) Although market makers also lose revenue to the high frequency trader in every trade, they are compensated for these losses by a higher liquidity discount. iii) High frequency trading increases the volatility of prices. iv) The volume of trades doubles as the high frequency trader intermediates all trades between the liquidity traders and market makers. This additional volume is a consequence of trades which are carefully tailored for surplus extraction and are neither driven by fundamentals nor is it noise trading. In equilibrium, high frequency trading and traditional market making coexist as competition drives down the profits for new high frequency traders while the presence of high frequency traders does not drive out traditional market makers. * We would like to thank Harrison Hong for his valuable comments and discussions. We are also grateful to Andrés Almazán, Gene Amromin, Michael Brennan, Pete Kyle and Eduardo Schwartz for their comments.We also thank seminar participants at CEMFI. The usual caveat applies. We welcome comments, including references we have inadvertently missed. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Banco de España.† alvaro.cartea@uc3m.es, Universidad Carlos III de Madrid. ‡ jpenalva@emp.uc3m.es, Universidad Carlos III de Madrid and Banco de España.

The Economics of High-Frequency Trading: Taking Stock

“…HFTs increase the transaction cost for others if they only add a layer of intermediation. Cartea & Penalva (2012) formalize this conjecture by analyzing HFTs that interpose themselves between liquidity traders and professional traders. These HFTs exploit their monopoly to extract part of the trade surplus and thus raise the cost of trading for OTs.…”

An ecological perspective on the future of computer trading

“…Zhang (2010) finds that HFT tends to increase volatility while Zhang and Powell (2011) discuss the impact of HFT on markets more broadly. Jarrow and Protter (2011) and Cartea and Penalva (2010) develop models in which HFT is generally harmful. On the other hand, Jovanovic and Menkveld (2010) find that an HFT market maker in Dutch stocks leads to a reduction of spreads by 29%, while Brogaard (2010) finds that in the US equity markets HFT contributes to price discovery and is generally beneficial.…”

Risk and Return in High-Frequency Trading

“…We then investigate through which channels relative latency benefits traders. Some theories view fast traders as using speed to trade on short-lived information, whether in reaction to news, order flow, or latency arbitrage (Cartea and Penalva 2012;Foucault et al, 2015;Foucault et al, 2016;Biais et al, 2015;and Roşu 2015). Other theories view speed as a way to avoid adverse selection and inventory costs (Jovanovic and Menkveld, 2015;Aït-Sahalia and Saglam, 2014;Hoffmann, 2014).…”