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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.
    • Handle: RePEc:bde:wpaper:1111
    as

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    References listed on IDEAS

    as
    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. Foucault, Thierry & Cespa, Giovanni, 2008. "Insiders-outsiders, transparency and the value of the ticker," HEC Research Papers Series 892, HEC Paris.
    4. Michael Kearns & Alex Kulesza & Yuriy Nevmyvaka, 2010. "Empirical Limitations on High Frequency Trading Profitability," Papers 1007.2593, arXiv.org, revised Sep 2010.
    5. 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.
    6. Menkveld, Albert J., 2013. "High frequency trading and the new market makers," Journal of Financial Markets, Elsevier, vol. 16(4), pages 712-740.
    7. 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.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

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