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The Impacts of Automation and High Frequency Trading on Market Quality

Author

Listed:
  • 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)

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.

Suggested Citation

  • Robert Litzenberger & Jeff Castura & Richard Gorelick, 2012. "The Impacts of Automation and High Frequency Trading on Market Quality," Annual Review of Financial Economics, Annual Reviews, vol. 4(1), pages 59-98, October.
  • Handle: RePEc:anr:refeco:v:4:y:2012:p:59-98
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    File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-110311-101744
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    References listed on IDEAS

    as
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    Cited by:

    1. Austin Gerig & David Michayluk, 2010. "Automated Liquidity Provision and the Demise of Traditional Market Making," Papers 1007.2352, arXiv.org.
    2. Aït-Sahalia, Yacine & Brunetti, Celso, 2020. "High frequency traders and the price process," Journal of Econometrics, Elsevier, vol. 217(1), pages 20-45.
    3. Hee Su Roh & Yinyu Ye, 2015. "Market Making with Model Uncertainty," Papers 1509.07155, arXiv.org, revised Nov 2015.
    4. Gerig, Austin & Michayluk, David, 2017. "Automated liquidity provision," Pacific-Basin Finance Journal, Elsevier, vol. 45(C), pages 1-13.

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    More about this item

    Keywords

    electronic markets; market efficiency; market regulation; automated market making;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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