Strategic Speed Choice by High-Frequency Traders under Speed Bumps
ISER DP No. 1050
43 Pages Posted: 10 Mar 2019
Date Written: February 17, 2019
We study how high-frequency traders (HFTs) strategically decide their speed level in a market with a random speed bump. If HFTs recognize the market impact of their speed decision, they perceive a wider bid-ask spread as an endogenous upward-sloping cost of being faster. We find that the speed elasticity of the bid-ask spread (slope of the endogenous cost function) negatively depends on the expected length of a speed bump since a longer delay makes market makers insensitive to HFTs' speed increment. Hence, speed bumps promote the investment of HFTs in high-speed technology by reducing the marginal cost of getting faster, undermining their intended purpose of protecting market makers. Depending on the expected length of a bump, an arms race among HFTs exhibits both complementarity and substitution. These findings explain the ambiguous empirical results regarding speed bumps and adverse selection for market makers.
Keywords: High-frequency trading, market structure, speed bumps, adverse selection, strategic speed decision
JEL Classification: D40, D47, G10, G18, G20
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