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The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response

85 Pages Posted: 30 Jan 2014 Last revised: 17 Mar 2015

Eric B. Budish

University of Chicago - Booth School of Business

Peter Cramton

University of Maryland - Department of Economics

John J. Shim

University of Chicago - Booth School of Business

Date Written: February 17, 2015

Abstract

The high-frequency trading arms race is a symptom of flawed market design. Instead of the continuous limit order book (CLOB) that is currently predominant, we argue that financial exchanges should use frequent batch auctions: uniform price double auctions conducted, e.g., every tenth of a second. That is, time should be treated as discrete instead of continuous, and orders should be processed in a batch auction instead of serially. Our argument has three parts. First, we use millisecond-level direct-feed data from exchanges to document a series of stylized facts about how the CLOB market design works at high-frequency time horizons: (i) correlations completely break down; which (ii) leads to obvious mechanical arbitrage opportunities; and (iii) competition has not affected the size or frequency of the arbitrage opportunities, it has only raised the bar for how fast one has to be to capture them. Second, we introduce a simple theory model which is motivated by, and helps explain, the empirical facts. The key insight is that obvious mechanical arbitrage opportunities, like those observed in the data, are built into the CLOB market design – continuous-time serialprocessing implies that even symmetrically observed public information creates arbitrage rents. These rents harm liquidity provision and induce a never-ending socially-wasteful arms race for speed. Last, we show that frequent batch auctions directly address the problems caused by the CLOB. Discrete time reduces the value of tiny speed advantages, and the auction transforms competition on speed into competition on price. Consequently, frequent batch auctions eliminate the mechanical arbitrage rents, enhance liquidity for investors, and stop the high-frequency trading arms race.

Suggested Citation

Budish, Eric B. and Cramton, Peter and Shim, John J., The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response (February 17, 2015). Chicago Booth Research Paper No. 14-03. Available at SSRN: https://ssrn.com/abstract=2388265 or http://dx.doi.org/10.2139/ssrn.2388265

Eric B. Budish (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-8453 (Phone)

Peter C. Cramton

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States
301-405-6987 (Phone)
301-405-3542 (Fax)

John J. Shim

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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