High Frequency Market Making During Stressed Periods

Abstract

High frequency market makers (HFMMs) are often viewed as an unreliable source of liquidity provision in times of high volatility. This paper studies the liquidity provision of HFMMs during high volatility periods. I find that, consistent with empirical evidence, HFMMs quote narrow spreads even when volatility is high, but they are not always present at the narrow spreads. Unlike traditional intermediaries, HFMMs manage adverse selection costs by decreasing the volume traded at the narrow spread. HFMMs effectively price discriminate between uninformed and informed investors by reducing the cross subsidization from uninformed investors to informed investors. As a result, uninformed investors pay a lower effective spread than informed investors. Market liquidity is improved and more gains from trade can be achieved in the presence of HFMMs. A policy to limit HFMMs' speed is a double-edged sword.

Keywords: high frequency trading, market making, adverse selection, price discrimination, speed limit policy

JEL Classification: G10