Liquidity Suppliers and High Frequency Trading

Abstract

This paper provides a mathematical analysis of how high frequency traders profit from their speed with respect to the limit order book. We show that their profits can be decomposed into two components. The first is due to their ability to execute market orders at limit order prices and without incurring any liquidity costs themselves. The second is by "front running" market orders with limit prices. These trading profits are shown to be at the expense of ordinary traders who submit market orders and sophisticated traders who submit limit orders or who use algorithmic trading to split up and execute large trades. We do not consider the welfare implications of our insights for the efficient functioning of financial markets. Introduction.One might (roughly) classify traders in financial markets into three rubrics: ordinary traders (OTs), sophisticated traders (STs), and high frequency traders (HFTs). The OTs, often individuals, generate small trades typically involving only a few hundred shares either using an electronic platform or a financial advisor. In contrast to OTs, we have STs, such as mutual funds, insurance companies, pension funds, etc., who typically make larger trades. To avoid large liquidity costs concomitant with such large trades, STs may farm out their trades to financial institutions (including hedge funds) who employ algorithmic strategies to break the large order into small pieces with rapid trading. These two groups, the OTs and the STs, hold securities for their investment value over relatively long time horizons. They trade based on information events or for portfolio rebalancing considerations. The third type of trader, the HFTs, are fundamentally different. They trade and hold securities only over extremely short time intervals. They trade seeking to earn profits, typically at the expense of the OTs, and especially at the expense of the STs, in spite of their use of algorithmic trading strategies to minimize liquidity costs.The speed advantage of the HFTs in their access to financial data and execution translates into three sources for their economic profits:1. Market power: The ability to trade strategically given a nontransitory quantity impact on prices. 2. Informed trading: The first to access market moving information.

Progressive Filtration Expansions via a Process, With Applications to Insider Trading

“…Note that this does not lead to an arbitrage opportunity a fortiori, but what is known as a statistical arbitrage opportunity. This is explained in [36], for example.…”

“…The claims are that the HFTs effectively have inside information. One way this could happen is a consequence of the analysis presented in a recent paper of Jarrow and Protter [36]. In brief, by the systematic use of IOC (immediate or cancel) orders, the HFT traders are able to construct a representation of the current state of the order book.…”

“…But one can take the analysis further, and by effectively front running the limit orders of institutional traders they ensure that limit orders are executed almost exclusively at their limits, with the HFT traders pocketing the spread between the market price and the limit order limit price. See [36] for details.…”