The Externalities of High Frequency Trading

56 Pages Posted: 26 May 2012 Last revised: 26 Dec 2019

See all articles by Mao Ye

Mao Ye

Cornell University; National Bureau of Economic Research (NBER); Cornell SC Johnson College of Business

Chen Yao

The Chinese University of Hong Kong (CUHK) - CUHK Business School

Jiading Gai

University of Illinois at Urbana-Champaign

Date Written: August 7, 2013

Abstract

When price competition is constrained by tick size, speed allocates the resources due to the time priority rule. We demonstrate three implications of competition in speed. 1) We find more high frequency liquidity provision for lower price stocks with high market cap, where the one cent tick size has a higher constraint on price competition. 2) Speed has no impact on (the price) of liquidity, because speed competition already implies that liquidity providers cannot undercut each other’s price. We find that exogenous technology improvements improving speed at a one millisecond, microsecond or nanosecond level do not lead to improvements on quoted spread, effective spread, trading volume or variance ratio. However, the cancellation/execution ratio increases, short term volatility increases and market depth decreases. 3) It is relative speed that matters. We find evidence consistent with the quote stuffing hypothesis (Biais and Woolley, 2011) using NASDAQ channel assignment as identification. Competition in speed but not price leads to externalities based on the canonical definition of Laffont (2008). One possible policy solution is the deregulation of tick size or decrease the importance of time priority.

Keywords: Externality, Positional Game, High-Frequency Trading, Liquidity, Price Efficiency, Quote Stuffing , Supercomputing

Suggested Citation

Ye, Mao and Yao, Chen and Gai, Jiading, The Externalities of High Frequency Trading (August 7, 2013). WBS Finance Group Research Paper No. 180, Available at SSRN: https://ssrn.com/abstract=2066839 or http://dx.doi.org/10.2139/ssrn.2066839

Mao Ye (Contact Author)

Cornell University ( email )

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National Bureau of Economic Research (NBER) ( email )

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Cornell SC Johnson College of Business ( email )

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Chen Yao

The Chinese University of Hong Kong (CUHK) - CUHK Business School ( email )

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HOME PAGE: http://sites.google.com/site/chenyaosite/research

Jiading Gai

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL Champaign 61820
United States