Abstract:
We consider a dynamic equilibrium model of high frequency trading (HFT). The model is a stochastic sequential game with endogenous trading decisions in a limit order market. There are two types of agents: fast and slow traders. Fast traders have speed advantages in terms of analysing information and the low-latency transmission of orders. Nevertheless, slow traders can observe and learn from the signals disclosed by fast traders in the market activity. We find that HFT improves market quality by increasing informational efficiency and liquidity. Fast traders make larger average trading profits than slow traders; however the trading profits of slow traders are higher when there is HFT in the market than in the case where HFT is absent. This is due to both the improvements in market quality induced by HFT and the learning process followed by slow traders, which increases the effectiveness of their trading strategies. We report that a cancellation fee, which has already been imposed by some exchanges, may affect negatively the market quality. Finally, we show that HFT traders may have incentives to manipulate market volatility since they can make larger profits through limit orders when we simulate a volatility shock.

Bernales, Alejandro, How Fast Can You Trade? High Frequency Trading in Dynamic Limit Order Markets (January 7, 2013). Available at SSRN: http://ssrn.com/abstract=2206953 or http://dx.doi.org/10.2139/ssrn.2206953

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