Middlemen in Limit Order Markets
We model high-frequency traders in electronic markets. We ask how the presence of such middlemen may affect welfare. We find that middlemen process public information faster than the average investor. As such, they can play a positive or a negative role. On the positive side, when they enter a market they can raise welfare by solving a pre-existing adverse selection problem. In that case their entry is accompanied by a rise in trade and a fall in bid-ask spreads, and they can raise welfare by up to 30% of the gap between its equilibrium level and its first-best level. On the negative side, they can create or exacerbate an adverse- selection problem, in which case spreads rise and trade declines. Our evidence on this score is mixed. On the one hand, middlemen’s participation lowers spreads but, on the other, it also lowers trade.
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