High-Frequency Trading, Endogenous Capital Commitment and Market Quality

Abstract

I study market quality implications of the competition between traditional market making and high-frequency trading. A long-run market maker responds to the competition from high-frequency traders by reducing both the spread and the amount of capital committed in market making. While a lower spread level is beneficial, less capital commitment deteriorates market quality. Specifically, the market's capacity to satisfy large demand is impaired. My model provides a more comprehensive illustration of high-frequency trading's implications on market quality by integrating both price and quantity effects. I further use this framework to analyze implications of different high-frequency trading regulatory measures.

Keywords: High-Frequency Trading, Market Quality

JEL Classification: G14