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Where is the Value in High Frequency Trading?

Author

Listed:
  • Álvaro Cartea

    (University College London, UK)

  • José Penalva

    (Universidad Carlos III de Madrid, Spain)

Abstract

We analyze the impact of high frequency (HF) trading in financial markets based on a model with three types of traders: liquidity traders (LTs), professional traders (PTs), and high frequency traders (HFTs). Our four main findings are: (i) The price impact of liquidity trades is higher in the presence of the HFTs and is increasing with the size of the trade. In particular, we show that HFTs reduce (increase) the prices that LTs receive when selling (buying) their equity holdings. (ii) Although PTs lose revenue in every trade intermediated by HFTs, they are compensated with a higher liquidity discount in the market price. (iii) HF trading increases the microstructure noise of prices. (iv) The volume of trades increases as the HFTs intermediate trades between the LTs and PTs. This additional volume is a consequence of trades which are carefully tailored for surplus extraction and are neither driven by fundamentals nor is it noise trading. In equilibrium, HF trading and PTs coexist as competition drives down the profits for new HFTs while the presence of HFTs does not drive out traditional PTs.

Suggested Citation

  • Álvaro Cartea & José Penalva, 2012. "Where is the Value in High Frequency Trading?," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 2(03), pages 1-46.
    • Handle: RePEc:wsi:qjfxxx:v:02:y:2012:i:03:n:s2010139212500140
    DOI: 10.1142/S2010139212500140
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    References listed on IDEAS

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    1. Foucault, Thierry & Cespa, Giovanni, 2008. "Insiders-outsiders, transparency and the value of the ticker," HEC Research Papers Series 892, HEC Paris.
    2. Terrence Hendershott & Ryan Riordan, 2009. "Algorithmic Trading and Information," Working Papers 09-08, NET Institute, revised Aug 2009.
    3. Menkveld, Albert J., 2013. "High frequency trading and the new market makers," Journal of Financial Markets, Elsevier, vol. 16(4), pages 712-740.
    4. Foucault, Thierry & Cespa, Giovanni, 2008. "Insiders-outsiders, transparency and the value of the ticker," HEC Research Papers Series 892, HEC Paris.
    5. Terrence Hendershott & Charles M. Jones & Albert J. Menkveld, 2011. "Does Algorithmic Trading Improve Liquidity?," Journal of Finance, American Finance Association, vol. 66(1), pages 1-33, February.
    6. Michael Kearns & Alex Kulesza & Yuriy Nevmyvaka, 2010. "Empirical Limitations on High Frequency Trading Profitability," Papers 1007.2593, arXiv.org, revised Sep 2010.
    7. Alain P. Chaboud & Benjamin Chiquoine & Erik Hjalmarsson & Clara Vega, 2014. "Rise of the Machines: Algorithmic Trading in the Foreign Exchange Market," Journal of Finance, American Finance Association, vol. 69(5), pages 2045-2084, October.
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    More about this item

    Keywords

    High frequency traders; high frequency trading; flash trading; liquidity traders; institutional investors; market microstructure; microstructure volatility; execution costs; market quality;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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