Regulating High Frequency Trading: A Micro-Level Analysis of Spatial Behavior, Optimal Choices, and Pareto-Efficiency in High Speed Markets

Abstract:     
The present paper considers the issue of High Frequency Trading (HFT) regulation. Rather than discussing macro-level effects of HFT that are still under debate (Sornette & Von der Becke, 2011) its analysis focuses on the issue of regulation from the perspective of HFT firms. Assuming that HFT generates benefits to firms by allowing them to trade at lower latencies than their competitors, binary choices of HFT investments yield Pareto-inefficient allocations if physical limits to latency reduction are taken into account. Adjustments in the payoff structure of the assumed model show that regulation can minimize negative externalities if the legislator is able to differentiate between market participants and their HFT strategies. The results of the alternated model indicate that legislators should be concerned about negative externalities of certain types of HFT firm behavior rather than about HFT itself. The transparency proposals of MifID II hence promise to serve as a finer tuned instrument for regulating HFT than a general financial transaction tax.

Number of Pages in PDF File: 24

Keywords: high frequency trading, prisoner's dilemma, regulation, von Thünen

JEL Classification: G18, G19, C72, C73, R1

working papers series