Trading Speed Competition: Can the Arms Race Go Too Far?

39 Pages Posted: 16 May 2016

See all articles by Dion Bongaerts

Dion Bongaerts

Erasmus University Rotterdam (EUR) - Finance

Lingtian Kong

Erasmus University Rotterdam (EUR) - Finance

Mark Van Achter

Erasmus University Rotterdam (EUR) - Finance

Date Written: May 14, 2016

Abstract

We analyze the likelihood of arms race behavior in markets with liquidity provision by HFTs. Liquidity providers (makers) and liquidity consumers (takers) make costly investments in monitoring speed. Competition among makers and takers induces arms race behavior. However, trade success probabilities increase in monitoring speed, giving rise to complementarity externalities between makers and takers. This counters negative arms race effects. Whether arms race effects materialize crucially depends on how marginal gains from trade depend on transaction speed. With the common (often implicit) assumption of constant marginal gains from trade, complementarity effects mostly dominate and market participants tend to under-invest in technology. However, with marginal gains from trade that decline in transaction speed, arms race behavior is much more likely. We provide micro-foundations for declining marginal gains from trade by a dynamic portfolio optimization problem with random rebalancing opportunities.

Keywords: High-Frequency Trading, Welfare, Liquidity

JEL Classification: G10, D61, D62, D43

Suggested Citation

Bongaerts, Dion and Kong, Lingtian and Van Achter, Mark, Trading Speed Competition: Can the Arms Race Go Too Far? (May 14, 2016). Available at SSRN: https://ssrn.com/abstract=2779904 or http://dx.doi.org/10.2139/ssrn.2779904

Dion Bongaerts

Erasmus University Rotterdam (EUR) - Finance ( email )

Burgemeester Oudlaan 50
Rotterdam, 3062PA
Netherlands
+31 (0) 10 40 82 790 (Phone)
+31 (0) 10 40 89 017 (Fax)

HOME PAGE: http://www.rsm.nl/portal/page/portal/home/faculty/academic_departments/finance/faculty_and_staff/fac

Lingtian Kong

Erasmus University Rotterdam (EUR) - Finance ( email )

United States

Mark Van Achter (Contact Author)

Erasmus University Rotterdam (EUR) - Finance ( email )

Burgemeester Oudlaan 50
P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 40 82 953 (Phone)
+31 10 40 89 017 (Fax)

HOME PAGE: http://www.rsm.nl/mvanachter

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