Where is the value in high frequency trading?

Álvaro Cartea () and José Penalva ()
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José Penalva: Banco de España

No 1111, Working Papers from 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.

Keywords: high frequency traders; high frequency trading; flash trading; liquidity traders; institutional investors; market microstructure (search for similar items in EconPapers)
JEL-codes: G12 G13 G14 G28 (search for similar items in EconPapers)
Pages: 52 pages
Date: 2011-05
New Economics Papers: this item is included in nep-cfn and nep-mst
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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Related works:
Journal Article: Where is the Value in High Frequency Trading? (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:bde:wpaper:1111

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