High Frequency Trading and Fragility

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may No 2020 / February 2017 AbstractWe show that limited dealer participation in the market, coupled with an informational friction resulting from high frequency trading, can induce demand for liquidity to be upward sloping and strategic complementarities in traders' liquidity consumption decisions: traders demand more liquidity when the market becomes less liquid, which in turn makes the market more illiquid, fostering the initial demand hike. This can generate market instability, where an initial dearth of liquidity degenerates into a liquidity rout (as in a flash crash). While in a transparent market, liquidity is increasing in the proportion of high frequency traders, in an opaque market strategic complementarities can make liquidity U-shaped in this proportion as well as in the degree of transparency. These episodes seem to have in common the fact that illiquidity brings more illiquidity, contrary to the dynamic that in normal market conditions illiquidity, by moderating the demand for immediacy, produces a self-stabilizing effect. In a crash, in contrast, an increase in illiquidity fosters a disorderly "run for the exit," accentuating the price movement.In the paper we trace this source of fragility to the fact that modern markets' pervasive presence of automated trading hampers market participants' access to (i) trade, and (ii) quote information. That is, two frictions shape trading activity nowadays: a participation friction (not all liquidity suppliers are continuously present in the market), and an informational friction (not all traders have access to timely market information).We model these two computerized-trading related frictions in a two-period dynamic noisy rational expectations model. We consider risk-averse dealers who provide liquidity to two cohorts of risk-averse, short-term traders who receive a common endowment shock. Dealers can be "full", with a continuous market presence as stylized high frequency traders (HFTs), or only be present in the first period market. In the first round of trade both dealers' types absorb the (market) orders of the first traders' cohort. In the second trading round, only full dealers participate. Full dealers can therefore accommodate the reverting orders of the first traders' cohort, as well as those of the incoming second cohort who only observe an imperfect signal about the first period order imbalance.We show that dealers' limited market participation favors the ...

Competition Among High-Frequency Traders, and Market Quality

“…Among the theoretical contributions are those of Ait-Sahalia and Saglam (2017),Biais et al (2015),Bongaerts and Achter (2016),Cespa and Vives (2019),Foucault et al (2016),Han et al (2014), Hoffmann (2014,Jovanovic and Menkveld (2016),Li (2014),Pagnotta and Philippon (2018),Rosu (2019), andVayanos andWang (2012).4 Benos et al (2017) also examine the extent to which the trading activity of HFTs is correlated and the impact on price efficiency.…”