54 Pages Posted: 21 Nov 2010 Last revised: 17 Feb 2012
Date Written: December 21, 2011
We analyze the impact of high frequency (HF) trading in financial markets based on a model with three types of traders: liquidity traders (LTs), professional traders (PTs), and high frequency traders (HFTs). Our four main findings are: i) The price impact of liquidity trades is higher in the presence of the HFTs and is increasing with the size of the trade. In particular, we show that HFTs reduce (increase) the prices that LTs receive when selling (buying) their equity holdings. ii) Although PTs lose revenue in every trade intermediated by HFTs, they are compensated with a higher liquidity discount in the market price. iii) HF trading increases the microstructure noise of prices. iv) The volume of trades increases as the HFTs intermediate trades between the LTs and PTs. This additional volume is a consequence of trades which are carefully tailored for surplus extraction and are neither driven by fundamentals nor is it noise trading. In equilibrium, HF trading and PTs coexist as competition drives down the profits for new HFTs while the presence of HFTs does not drive out traditional PTs.
Keywords: High frequency traders, high frequency trading, flash trading, liquidity traders, institutional investors, market microstructure, microstructure volatility, execution costs, market quality
JEL Classification: G12, G13, G14, G28
Suggested Citation: Suggested Citation