High frequency market making during stressed periods

Ke Xu

International Review of Economics & Finance, 2023, vol. 87, issue C, 379-397

Abstract: High frequency market makers (HFMMs) are often viewed as an unreliable source of liquidity provision. This paper studies the liquidity provision of HFMMs during high volatility periods when adverse selection is high. I find that, consistent with empirical evidence, HFMMs quote narrow spreads even when volatility is high, but they are not always present at the narrow spreads. Unlike traditional intermediaries, HFMMs manage adverse selection costs by decreasing the volume traded at the narrow spread. HFMMs effectively price discriminate between uninformed and informed investors by reducing the cross-subsidization from uninformed investors to informed investors. As a result, uninformed investors pay a lower effective spread than informed investors. HFMMs improve market liquidity and increase gains from trade especially when adverse selection is high. A policy to limit HFMMs’ speed is a double-edged sword.

Keywords: High frequency trading; Market making; Adverse selection; Price discrimination; Speed limit policy (search for similar items in EconPapers)
JEL-codes: G10 (search for similar items in EconPapers)
Date: 2023
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:87:y:2023:i:c:p:379-397

DOI: 10.1016/j.iref.2023.05.001

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