A dynamic limit order market with fast and slow traders
We study a dynamic limit order market where agents may invest into a trading technology that grants them a speed advantage over others. Being fast is valuable because it allows limit orders to be revised quickly in the light of new information and therefore reduces the risk of being picked off. Even though this can generate more trading, the equilibrium level of investment is excessive and always generates a welfare loss because fast traders exert negative externalities on slow agents and are able to extract any surplus. If the diffusion of trading technology additionally leads to a more efficient trading process, this result may reverse completely. For sufficiently large efficiency gains, fast traders exert positive externalities on slow market participants and their presence leads to an increase in social welfare, albeit the equilibrium level of investment is below the social optimum. Our results imply that the marginal impact of investments related to algorithmic and high-frequency trading on social welfare crucially depends on the pre-investment level of market efficiency.
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