Abstract

http://ssrn.com/abstract=2388265
 
 

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The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response


Eric B. Budish


University of Chicago - Booth School of Business

Peter Cramton


University of Maryland - Department of Economics

John J. Shim


University of Chicago - Booth School of Business

December 23, 2013

Fama-Miller Working Paper
Chicago Booth Research Paper No. 14-03

Abstract:     
We argue that the continuous limit order book is a flawed market design and propose that financial exchanges instead use frequent batch auctions: uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals, e.g., every 1 second. Our argument has four parts. First, we use millisecond-level direct-feed data from exchanges to show that the continuous limit order book market design does not really “work” in continuous time: market correlations completely break down at high-frequency time horizons. Second, we show that this correlation breakdown creates frequent technical arbitrage opportunities, available to whomever is fastest, which in turn creates an arms race to exploit such opportunities. Third, we develop a simple new theory model motivated by these empirical facts. The model shows that the arms race is not only socially wasteful – a prisoner’s dilemma built directly into the market design – but moreover that its cost is ultimately borne by investors via wider spreads and thinner markets. Last, we show that frequent batch auctions eliminate the arms race, both because they reduce the value of tiny speed advantages and because they transform competition on speed into competition on price. Consequently, frequent batch auctions lead to narrower spreads, deeper markets, and increased social welfare.

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Date posted: January 30, 2014 ; Last revised: March 12, 2014

Suggested Citation

Budish, Eric B. and Cramton, Peter and Shim, John J., The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response (December 23, 2013). Fama-Miller Working Paper; Chicago Booth Research Paper No. 14-03. Available at SSRN: http://ssrn.com/abstract=2388265 or http://dx.doi.org/10.2139/ssrn.2388265

Contact Information

Eric B. Budish (Contact Author)
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-8453 (Phone)
Peter C. Cramton
University of Maryland - Department of Economics ( email )
College Park, MD 20742
United States
301-405-6987 (Phone)
301-405-3542 (Fax)
John J. Shim
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
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