Fast Trading and the Virtue of Entropy: Evidence from the Foreign Exchange Market

52 Pages Posted: 30 Jul 2019

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Romain Lafarguette

International Monetary Fund; European Central Bank (ECB)

Arnaud Mehl

European Central Bank (ECB)

Date Written: July, 2019

Abstract

Focusing on the foreign exchange reaction to macroeconomic announcements, we show that fast trading is positively and significantly correlated with the entropy of the distribution of quoted prices in reaction to news: a larger share of fast trading increases the degree of diversity of quotes in the order book, for given liquidity, order book depth and size of order flows. Exploiting the WM Reuters’ reform of the fixing methodology in February 2015 as a natural experiment, we provide evidence that fast trading raises entropy, rather than reacting to it. While more entropy in quoted prices means noisier information and arguably complicates price discovery from an individual trader’s perspective, we show that, in the aggregate, more entropy actually brings traded prices closer to the random walk hypothesis, and improves indicators of market efficiency and quality of trade execution. We estimate that a 10 percent increase in entropy reduces the negative impact of macro news by over 60% for effective spreads, against over 40% for realized spreads and price impacts. Our findings suggest that the main mechanism by which fast trading may have desirable effects on market performance specifically hinges on enhanced heterogeneity in trading patterns, best captured by entropy.

Keywords: asset pricing, high-frequency quoting, macroeconomic news, market efficiency, quality of trade execution, random walk

JEL Classification: F31, G14, G15

Suggested Citation

Corsetti, Giancarlo and Lafarguette, Romain and Mehl, Arnaud, Fast Trading and the Virtue of Entropy: Evidence from the Foreign Exchange Market (July, 2019). ECB Working Paper No. 2300, Available at SSRN: https://ssrn.com/abstract=3428971

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Romain Lafarguette

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Arnaud Mehl

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
54
Abstract Views
322
rank
443,444
PlumX Metrics