High Frequency Trading with Speed Hierarchies

Abstract

Traders differ in speed and their speed differences matter. This paper models the competition
between fast traders (FTs) who react at varying speeds upon observing a common signal about
incoming orders placed by normal-speed traders. I find that the outcome of competition between
FTs depends crucially on the hierarchical structure of FTs’ speed: (1) FTs’ aggregate market
power increases when their speeds are more heterogeneous, (2) entries of new FTs may increase
FTs’ aggregate market power, and (3) even when infinitely many FTs compete their aggregate
market power does not vanish except in rare special cases. This paper also demonstrates the
limitations of some traditional measures of market quality: although FTs in the model increase
trading volume, trade against normal-speed liquidity demanders, accelerate price discovery, and
trade in informative directions, normal-speed liquidity demanders are worse off and prices are
ultimately less informative as a result of FTs’ trading.

Keywords: high frequency trading, market microstructure, liquidity, market efficiency, Kyle model

JEL Classification: G12, G14, G18, D42, D43, D47, D82, D83, D84