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Where are the risks in high frequency trading?

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  • Foucault, T.

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.

Suggested Citation

  • Foucault, T., 2016. "Where are the risks in high frequency trading?," Financial Stability Review, Banque de France, issue 20, pages 53-67, April.
    • Handle: RePEc:bfr:fisrev:2016:20:6
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    References listed on IDEAS

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    1. Thierry Foucault & Roman Kozhan & Wing Wah Tham, 2017. "Toxic Arbitrage," The Review of Financial Studies, Society for Financial Studies, vol. 30(4), pages 1053-1094.
    2. Biais, Bruno & Foucault, Thierry & Moinas, Sophie, 2015. "Equilibrium fast trading," Journal of Financial Economics, Elsevier, vol. 116(2), pages 292-313.
    3. Vincent Van Kervel & Albert J. Menkveld, 2019. "High‐Frequency Trading around Large Institutional Orders," Journal of Finance, American Finance Association, vol. 74(3), pages 1091-1137, June.
    4. Foucault, Thierry & Pagano, Marco & Roell, Ailsa, 2013. "Market Liquidity: Theory, Evidence, and Policy," OUP Catalogue, Oxford University Press, number 9780199936243.
    5. Brian M. Weller, 2018. "Does Algorithmic Trading Reduce Information Acquisition?," The Review of Financial Studies, Society for Financial Studies, vol. 31(6), pages 2184-2226.
    6. Dugast, Jérôme & Foucault, Thierry, 2018. "Data abundance and asset price informativeness," Journal of Financial Economics, Elsevier, vol. 130(2), pages 367-391.
    7. Albert S. Kyle & S. Viswanathan, 2008. "How to Define Illegal Price Manipulation," American Economic Review, American Economic Association, vol. 98(2), pages 274-279, May.
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    9. Jérôme Dugast, 2018. "Unscheduled News and Market Dynamics," Journal of Finance, American Finance Association, vol. 73(6), pages 2537-2586, December.
    10. Hirshleifer, Jack, 1971. "The Private and Social Value of Information and the Reward to Inventive Activity," American Economic Review, American Economic Association, vol. 61(4), pages 561-574, September.
    11. Vincent van Kervel, 2015. "Competition for Order Flow with Fast and Slow Traders," The Review of Financial Studies, Society for Financial Studies, vol. 28(7), pages 2094-2127.
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    Cited by:

    1. Tobias Braun & Jonas A Fiegen & Daniel C Wagner & Sebastian M Krause & Thomas Guhr, 2018. "Impact and recovery process of mini flash crashes: An empirical study," PLOS ONE, Public Library of Science, vol. 13(5), pages 1-11, May.
    2. Tobias Braun & Jonas A. Fiegen & Daniel C. Wagner & Sebastian M. Krause & Thomas Guhr, 2017. "Impact and Recovery Process of Mini Flash Crashes: An Empirical Study," Papers 1707.05580, arXiv.org.

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