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Where is the value in high frequency trading?

Author

Listed:
  • Álvaro Cartea

    () (Universidad Carlos III de Madrid)

  • José Penalva

    () (Banco de España)

Abstract

We analyze the impact of high frequency trading in financial markets based on a model with three types of traders: liquidity traders, market makers, and high frequency traders. Our four main findings are: i) The price impact of the liquidity trades is higher in the presence of the high frequency trader and is increasing with the size of the trade. In particular, we show that the high frequency trader reduces (increases) the prices that liquidity traders receive when selling (buying) their equity holdings. ii) Although market makers also lose revenue to the high frequency trader in every trade, they are compensated for these losses by a higher liquidity discount. iii) High frequency trading increases the volatility of prices. iv) The volume of trades doubles as the high frequency trader intermediates all trades between the liquidity traders and market makers. 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, high frequency trading and traditional market making coexist as competition drives down the profits for new high frequency traders while the presence of high frequency traders does not drive out traditional market makers.

Suggested Citation

  • Álvaro Cartea & José Penalva, 2011. "Where is the value in high frequency trading?," Working Papers 1111, Banco de España;Working Papers Homepage.
  • Handle: RePEc:bde:wpaper:1111
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    File URL: http://www.bde.es/f/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosTrabajo/11/Fich/dt1111e.pdf
    File Function: First version, May 2011
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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," Les Cahiers de Recherche 892, HEC Paris.
    2. 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.
    3. 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.
    4. Alain P. Chaboud & Benjamin Chiquoine & Erik Hjalmarsson & Clara Vega, 2009. "Rise of the machines: algorithmic trading in the foreign exchange market," International Finance Discussion Papers 980, Board of Governors of the Federal Reserve System (U.S.).
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. repec:eee:pacfin:v:45:y:2017:i:c:p:1-13 is not listed on IDEAS
    2. Hoffmann, Peter, 2013. "A dynamic limit order market with fast and slow traders," Working Paper Series 1526, European Central Bank.
    3. repec:exl:2manag:v:17:y:2016:i:2:p:241-260 is not listed on IDEAS
    4. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 44621, University Library of Munich, Germany, revised Jan 2013.
    5. Gerig, Austin & Michayluk, David, 2017. "Automated liquidity provision," Pacific-Basin Finance Journal, Elsevier, vol. 45(C), pages 1-13.
    6. Brogaard, Jonathan & Hendershott, Terrence & Riordan, Ryan, 2013. "High frequency trading and price discovery," Working Paper Series 1602, European Central Bank.
    7. Linton, O. & Mahmoodzadeh, S., 2018. "Implications of High-Frequency Trading for Security Markets," Cambridge Working Papers in Economics 1802, Faculty of Economics, University of Cambridge.
    8. Henryk Gurgul & Robert Syrek & Christoph Mitterer, 2016. "Price duration versus trading volume in high-frequency data for selected DAX companies," Managerial Economics, AGH University of Science and Technology, vol. 17(2), pages 241-260, December.
    9. Austin Gerig & David Michayluk, 2010. "Automated Liquidity Provision and the Demise of Traditional Market Making," Papers 1007.2352, arXiv.org.
    10. Jain, Pankaj K. & Jain, Pawan & McInish, Thomas H., 2016. "Does high-frequency trading increase systemic risk?," Journal of Financial Markets, Elsevier, vol. 31(C), pages 1-24.
    11. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 39855, University Library of Munich, Germany.

    More about this item

    Keywords

    high frequency traders; high frequency trading; flash trading; liquidity traders; institutional investors; market microstructure;

    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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