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The Impacts of Automation and High Frequency Trading on Market Quality

  • 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)

Registered author(s):

    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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    File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-110311-101744
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    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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    1. French, Kenneth R. & Roll, Richard, 1986. "Stock return variances : The arrival of information and the reaction of traders," Journal of Financial Economics, Elsevier, vol. 17(1), pages 5-26, September.
    2. Chordia, Tarun & Roll, Richard & Subrahmanyam, Avanidhar, 2008. "Liquidity and market efficiency," Journal of Financial Economics, Elsevier, vol. 87(2), pages 249-268, February.
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