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The Impacts of Automation and High Frequency Trading on Market Quality

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Author Info

  • Robert Litzenberger

    (Finance Department, Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104
    RGM Advisors, LLC, Austin, Texas 78701)

  • Jeff Castura

    ()
    (RGM Advisors, LLC, Austin, Texas 78701)

  • Richard Gorelick

    (RGM Advisors, LLC, Austin, Texas 78701)

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    Abstract

    In recent decades, US equity markets have changed from predominantly manual markets with limited competition to highly automated and competitive markets. These changes occurred earlier for NASDAQ stocks (primarily between 1994 and 2004) and later for NYSE-listed stocks (mostly following Reg NMS and the 2006 introduction of the NYSE hybrid market). This paper surveys the evidence of how these changes impacted market quality and shows that overall market quality has improved significantly, including bid-ask spreads, liquidity, and transitory price impacts (measured by short-term variance ratios). The greater improvement in market quality for NYSE-listed stocks relative to NASDAQ stocks beginning in 2006 suggests causal links between the staggered market structure changes and market quality. Using proprietary data sets, provided by two exchanges, that identify the activity of high frequency trading firms, studies show these firms contributed directly to narrowing bid-ask spreads, increasing liquidity, and reducing intraday transitory pricing errors and intraday volatility.

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    Bibliographic Info

    Article provided by Annual Reviews in its journal Annual Review of Financial Economics.

    Volume (Year): 4 (2012)
    Issue (Month): 1 (October)
    Pages: 59-98

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    Handle: RePEc:anr:refeco:v:4:y:2012:p:59-98

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    Related research

    Keywords: electronic markets; market efficiency; market regulation; automated market making;

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    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Austin Gerig & David Michayluk, 2010. "Automated Liquidity Provision and the Demise of Traditional Market Making," Papers 1007.2352, arXiv.org.
    2. Fama, Eugene F, 1970. "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, American Finance Association, vol. 25(2), pages 383-417, May.
    3. Hendershott, Terrence & Jones, Charles M. & Menkveld, Albert J., 2008. "Does algorithmic trading improve liquidity?," CFS Working Paper Series 2008/41, Center for Financial Studies (CFS).
    4. Christie, William G & Schultz, Paul H, 1994. " Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?," Journal of Finance, American Finance Association, American Finance Association, vol. 49(5), pages 1813-40, December.
    5. Albert J. Menkveld, 2011. "High Frequency Trading and the New-Market Makers," Tinbergen Institute Discussion Papers 11-076/2/DSF21, Tinbergen Institute, revised 15 Aug 2011.
    6. Lawrence R. Glosten & Paul R. Milgrom, 1983. "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 570, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    7. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1315-35, November.
    8. Hendershott, Terrence & Moulton, Pamela C., 2011. "Automation, speed, and stock market quality: The NYSE's Hybrid," Journal of Financial Markets, Elsevier, Elsevier, vol. 14(4), pages 568-604, November.
    9. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, American Economic Association, vol. 70(3), pages 393-408, June.
    10. Andrew W. Lo, A. Craig MacKinlay, 1988. "Stock Market Prices do not Follow Random Walks: Evidence from a Simple Specification Test," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 1(1), pages 41-66.
    11. French, Kenneth R. & Roll, Richard, 1986. "Stock return variances : The arrival of information and the reaction of traders," Journal of Financial Economics, Elsevier, Elsevier, vol. 17(1), pages 5-26, September.
    12. Barclay, Michael J & Litzenberger, Robert H & Warner, Jerold B, 1990. "Private Information, Trading Volume, and Stock-Return Variances," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 3(2), pages 233-53.
    13. James A. Bennett, 2003. "Greener Pastures and the Impact of Dynamic Institutional Preferences," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 16(4), pages 1203-1238.
    14. Albert J. Menkveld, 2011. "High Frequency Trading and the New-Market Makers," Tinbergen Institute Discussion Papers 11-076/2/DSF21, Tinbergen Institute, revised 15 Aug 2011.
    15. Chordia, Tarun & Roll, Richard & Subrahmanyam, Avanidhar, 2008. "Liquidity and market efficiency," Journal of Financial Economics, Elsevier, Elsevier, vol. 87(2), pages 249-268, February.
    16. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, Elsevier, vol. 9(3), pages 221-235, September.
    17. Kraus, Alan & Stoll, Hans R, 1972. "Price Impacts of Block Trading on the New York Stock Exchange," Journal of Finance, American Finance Association, American Finance Association, vol. 27(3), pages 569-88, June.
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    Cited by:
    1. Austin Gerig & David Michayluk, 2014. "Automated Liquidity Provision," Research Paper Series, Quantitative Finance Research Centre, University of Technology, Sydney 345, Quantitative Finance Research Centre, University of Technology, Sydney.

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