High Frequency Market Making

Yacine Ait-Sahalia

Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Mehmet Sağlam

University of Cincinnati - Department of Finance - Real Estate

June 1, 2016

We propose an inventory-based model of market making where a strategic high frequency trader exploits his speed and informational advantages to place quotes that interact with low frequency traders. We characterize the optimal market making policy analytically, illustrate that it generates endogenous order cancellations, and compute the long-run equilibrium bid-ask spread and other liquidity measures. The model predicts that the high-frequency trader provides more liquidity as he gets faster and shies away from it as volatility increases due to a higher risk of his stale quotes being picked by arbitrageurs. Competition with another liquidity provider increases improves the overall liquidity. Finally, we provide the first formal, model-based analysis of the impact of four widely discussed policies designed to regulate high frequency trading: imposing a transactions tax, setting minimum-time limits before quotes can be cancelled, taxing the cancellations of limit orders, and replacing time priority with a pro rata or random allocation. We find that these policies are largely unable to even out the speed and informational advantages of high frequency market makers.

Number of Pages in PDF File: 72

Keywords: High Frequency Trading, Market Making, Liquidity, Order Cancellations, Competition for Order Flow, Tobin Tax, Order Resting Time, Order Cancellation Tax

JEL Classification: G10

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Date posted: September 28, 2013 ; Last revised: June 10, 2016

Suggested Citation

Ait-Sahalia, Yacine and Sağlam, Mehmet, High Frequency Market Making (June 1, 2016). Available at SSRN: https://ssrn.com/abstract=2331613 or http://dx.doi.org/10.2139/ssrn.2331613

Contact Information

Yacine Ait-Sahalia (Contact Author)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Princeton University - Department of Economics ( email )
Fisher Hall
Princeton, NJ 08544
United States
609-258-4015 (Phone)
609-258-5398 (Fax)

Mehmet Sağlam
University of Cincinnati - Department of Finance - Real Estate ( email )
College of Business Administration
Cincinnati, OH 45221
United States
(513) 556-9108 (Phone)
HOME PAGE: http://homepages.uc.edu/~saglammt/
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