A Dynamic Limit Order Market with Fast and Slow Traders

Abstract

We study the role of high-frequency trading in a dynamic limit order market. Fast traders' ability to revise their quotes quickly after news arrivals helps to reduce the inefficiency that is rooted in the risk of being "picked off", which increases trade. However, their presence induces slow traders to strategically submit limit orders with a lower execution probability, thereby reducing trade. Because speed is a source of market power, it enables fast traders to extract rents from others and triggers a costly arms race that reduces social welfare. The model generates a number of testable implications concerning the effects of high-frequency trading in limit order markets.

Keywords: High-frequency trading, Limit Order Markets

JEL Classification: G19, C72, D62