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Toxic Arbitrage

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  • Foucault , Thierry

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  • Kozhan , Roman

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Abstract

High frequency arbitrage opportunities arise when the price of one asset follows, with a lag, changes in the value of another related asset due to information arrival. These opportunities are toxic because they expose liquidity suppliers to the risk of being picked off by arbitrageurs. Hence, more frequent toxic arbitrage opportunities and a faster arbitrageurs' response to these opportunities impair liquidity. The authors find support for these predictions using high frequency triangular arbitrage opportunities in the FX market. In their sample, a 1% increase in the likelihood that a toxic arbitrage terminates with an arbitrageur's trade (rather than a quote update) raises bid-ask spreads by about 4%.

Suggested Citation

  • Foucault , Thierry & Kozhan , Roman, 2014. "Toxic Arbitrage," HEC Research Papers Series 1040, HEC Paris.
  • Handle: RePEc:ebg:heccah:1040
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    1. Cartea, Álvaro & Payne, Richard & Penalva, José & Tapia, Mikel, 2019. "Ultra-fast activity and intraday market quality," Journal of Banking & Finance, Elsevier, vol. 99(C), pages 157-181.
    2. Gunther Capelle-Blancard, 2018. "What is the Point of (the Hundreds of Thousands of Billions of) Stock Transactions?," Comparative Economic Studies, Palgrave Macmillan;Association for Comparative Economic Studies, vol. 60(1), pages 15-33, March.
    3. Songzi Du & Haoxiang Zhu, 2014. "Welfare and Optimal Trading Frequency in Dynamic Double Auctions," NBER Working Papers 20588, National Bureau of Economic Research, Inc.
    4. Lisa Anderson & Emad Andrews & Baiju Devani & Michael Mueller & Adrian Walton, 2018. "Speed Segmentation on Exchanges: Competition for Slow Flow," Staff Working Papers 18-3, Bank of Canada.
    5. Miriam Marra, 2017. "Explaining co-movements between equity and CDS bid-ask spreads," Review of Quantitative Finance and Accounting, Springer, vol. 49(3), pages 811-853, October.
    6. Hautsch, Nikolaus & Scheuch, Christoph & Voigt, Stefan, 2018. "Limits to arbitrage in markets with stochastic settlement latency," CFS Working Paper Series 616, Center for Financial Studies (CFS).
    7. Oliver Linton & Soheil Mahmoodzadeh, 2018. "Implications of High-Frequency Trading for Security Markets," Annual Review of Economics, Annual Reviews, vol. 10(1), pages 237-259, August.
    8. Mila Getmansky & Ravi Jagannathan & Loriana Pelizzon & Ernst Schaumburg & Darya Yuferova, 2017. "Stock Price Crashes: Role of Slow-Moving Capital," NBER Working Papers 24098, National Bureau of Economic Research, Inc.
    9. Darolles, Serge & Le Fol, Gaëlle & Mero, Gulten, 2017. "Mixture of distribution hypothesis: Analyzing daily liquidity frictions and information flows," Journal of Econometrics, Elsevier, vol. 201(2), pages 367-383.
    10. Viktor Manahov, 2018. "The rise of the machines in commodities markets: new evidence obtained using Strongly Typed Genetic Programming," Annals of Operations Research, Springer, vol. 260(1), pages 321-352, January.
    11. Gunther Capelle-Blancard, 2017. "À quoi servent les (centaines de milliers de milliards de) transactions boursières ?," Revue d'économie financière, Association d'économie financière, vol. 0(3), pages 37-58.
    12. Breckenfelder, Johannes, 2019. "Competition among high-frequency traders, and market quality," Working Paper Series 2290, European Central Bank.
    13. Gulten Mero & Serge Darolles & Gaëlle Le Fol, 2015. "Financial Market Liquidity: Who Is Acting Strategically?," THEMA Working Papers 2015-14, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
    14. Lescourret, Laurence & Moinas, Sophie, 2014. "Liquidity Supply across Multiple Trading Venues," TSE Working Papers 14-533, Toulouse School of Economics (TSE), revised Mar 2015.
    15. Foucault, Thierry & Moinas, Sophie, 2018. "Is Trading Fast Dangerous?," TSE Working Papers 18-881, Toulouse School of Economics (TSE).
    16. Jun Aoyagi, 2019. "Strategic Speed Choice by High-Frequency Traders under Speed Bumps," ISER Discussion Paper 1050, Institute of Social and Economic Research, Osaka University.
    17. Bernales, Alejandro & Garrido, Nicolás & Sagade, Satchit & Valenzuela, Marcela & Westheide, Christian, 2020. "Trader Competition in Fragmented Markets: Liquidity Supply versus Picking-off Risk," SAFE Working Paper Series 234, Leibniz Institute for Financial Research SAFE.
    18. Zhou, Hao & Kalev, Petko S., 2019. "Algorithmic and high frequency trading in Asia-Pacific, now and the future," Pacific-Basin Finance Journal, Elsevier, vol. 53(C), pages 186-207.
    19. Nikolaus Hautsch & Christoph Scheuch & Stefan Voigt, 2018. "Building Trust Takes Time: Limits to Arbitrage in Blockchain-Based Markets," Papers 1812.00595, arXiv.org, revised Feb 2021.
    20. Foucault, T., 2016. "Where are the risks in high frequency trading?," Financial Stability Review, Banque de France, issue 20, pages 53-67, April.

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    More about this item

    Keywords

    Arbitrage; Adverse Selection; Liquidity; High Frequency Trading;
    All these keywords.

    JEL classification:

    • D50 - Microeconomics - - General Equilibrium and Disequilibrium - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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