High frequency trading and fragility

Giovanni Cespa and Xavier Vives

No 2020, Working Paper Series from European Central Bank

Abstract: We show that limited dealer participation in the market, coupled with an informational friction resulting from high frequency trading, can induce demand for liquidity to be upward sloping and strategic complementarities in traders' liquidity consumption decisions: traders demand more liquidity when the market becomes less liquid, which in turn makes the market more illiquid, fostering the initial demand hike. This can generate market instability, where an initial dearth of liquidity degenerates into a liquidity rout (as in a flash crash). While in a transparent market, liquidity is increasing in the proportion of high frequency traders, in an opaque market strategic complementarities can make liquidity U-shaped in this proportion as well as in the degree of transparency. JEL Classification: G10, G12, G14

Keywords: asymmetric information; flash crash; high frequency trading; market fragmentation (search for similar items in EconPapers)
Date: 2017-02
New Economics Papers: this item is included in nep-mst
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Related works:
Working Paper: High Frequency Trading and Fragility (2017)
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