Equilibrium High Frequency Trading

36 Pages Posted: 8 May 2011 Last revised: 15 Mar 2013

Thierry Foucault

HEC Paris - Finance Department

Sophie Moinas

Toulouse School of Economics

Bruno Biais

Centre for Economic Policy Research (CEPR)

Date Written: September 2011

Abstract

Algorithms enable investors to locate trading opportunities, which raises gains from trade. Algorithmic traders can also process information on stock values before slow traders, which generates adverse selection. We model trading in this context and show that, for a given level of algorithmic trading, multiple equilibria can arise, some of which generate market exclusion for slow traders and sharp increases in the price impact of trades. We offer a theoretical interpretation for the "flash-crash" of may 2010. Next, we analyze the equilibrium level of investment in algorithmic trading. Because when others become fast it increases adverse selection costs for slow investors, algo-trading generates negative externalities. Therefore the equilibrium level of algo-trading exceeds its utilitarian welfare maximizing counterpart. Furthermore, since it involves fixed costs, investment in algorithmic trading is more pro table for large institutions than for small ones. This generates equilibrium informational asymmetries between large fast traders and small slow traders.

JEL Classification: G10, G18, G20

Suggested Citation

Foucault, Thierry and Moinas, Sophie and Biais, Bruno, Equilibrium High Frequency Trading (September 2011). International Conference of the French Finance Association (AFFI), May 2011. Available at SSRN: https://ssrn.com/abstract=1834344

Thierry Foucault (Contact Author)

HEC Paris - Finance Department ( email )

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France
(33)139679569 (Phone)
(33)139677085 (Fax)

HOME PAGE: http://thierryfoucault.com/

Sophie Moinas

Toulouse School of Economics ( email )

Toulouse 1 Capitole University
Place Anatole-France
Toulouse Cedex, F-31042
France

Bruno Biais

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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