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High-Frequency Trading and Market Performance

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  • Markus Baldauf

    (Stanford University)

  • Joshua Mollner

    (Stanford University)

Abstract

High-frequency trading has transformed financial markets in recent years. We study the consequences of this development using a model with multiple trading venues, costly information acquisition, and several types of traders. An increase in trading speed crowds out information acquisition by reducing the gains from trading against mispriced quotes. Thus, faster speeds have two effects on traditional measures of market performance. First, the bid-ask spread declines, since there are fewer informational asymmetries. Second, price efficiency deteriorates, since less information is available to be incorporated into prices. A general tradeoff exists between low spreads and price efficiency. We characterize the frontier of this tradeoff and evaluate several trading mechanisms within this framework. The prevalent limit order book mechanism generally does not induce outcomes on this frontier. We consider two alternatives: first, a small delay added to the processing of all orders except cancellations, and second, frequent batch auctions. Both induce equilibrium outcomes on this frontier.

Suggested Citation

  • Markus Baldauf & Joshua Mollner, 2015. "High-Frequency Trading and Market Performance," Discussion Papers 15-017, Stanford Institute for Economic Policy Research.
    • Handle: RePEc:sip:dpaper:15-017
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    Cited by:

    1. Markus Baldauf & Joshua Mollner, 2015. "Trading in Fragmented Markets," Discussion Papers 15-018, Stanford Institute for Economic Policy Research.
    2. Breedon, Francis & Chen, Louisa & Ranaldo, Angelo & Vause, Nicholas, 2023. "Judgment day: Algorithmic trading around the Swiss franc cap removal," Journal of International Economics, Elsevier, vol. 140(C).
    3. Cécile Bastidon, 2017. "Stock markets fragmentation, volatility and final investors," Annals of Finance, Springer, vol. 13(4), pages 435-451, November.
    4. Tomy Lee, 2019. "Latency in Fragmented Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 33, pages 128-153, July.

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