Where are the risks in high frequency trading?

Thierry Foucault

Financial Stability Review, 2016, issue 20, 53-67

Abstract: Progress in information and trading technologies have contributed to the development of high frequency traders (HFTs), that is, traders whose trading strategies rely on extremely fast reaction to market events. In this paper, the author describes HFTs’ strategies and how they rely on speed. He then discusses how some of these strategies might create risks for financial markets. In particular, he emphasises the fact that extremely fast reaction to information can raise adverse selection costs and undermine incentives to produce information, reducing market participants’ ability to share risks efficiently and asset price informativeness for resources allocation. The author also discusses recent extreme short-lived price dislocations in financial markets (e.g. the 2010 Flash crash) and argues that these events are more likely to be due to automation of trading and structural changes in market organisation rather than high frequency trading per se. Throughout he argues that regulation of high frequency trading should target specific trading strategies rather than fast trading in general.

Date: 2016
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