Arms Sales in Financial Markets

Abstract

Many financial transactions are of a fixed-sum nature, meaning that improvements in the terms of trade for one party often come at the expense of another party.  We model the feedback loop between the sales of trading advantages (e.g., data or co-location services) and traders' endogenous participation in financial markets.  A trader's benefit from purchasing trading advantages increases with aggregate market participation, but the benefit of participating decreases with other traders' purchases of trading advantages. In equilibrium, sellers of trading advantages (e.g., data providers or securities exchanges) may maximize their profits by prompting inefficiently low market participation and liquidity.

Keywords: JEL Codes: G20, G14, D82, D42

JEL Classification: G20, G14, D82, D42