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How does competition among high-frequency traders affect market liquidity?

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  • Breckenfelder, Johannes

Abstract

When high-frequency trading firms compete, does stock market liquidity deteriorate? I argue that the answer is yes. High-frequency trading competition may impact stock market liquidity via two channels. First, more competition is accompanied by more high-frequency trading and larger trading volumes, which improve market liquidity. Second, more competition may mean that high-frequency traders adapt their trading strategies and engage in more speculative trades, which harms market liquidity. Since these two channels have the opposite effects on market liquidity, it is important to disentangle the effects of competition from those of a mere increase in the number/volume of high-frequency trading transactions. In the analysis, I aim to do precisely this, by using an exogenous event which changed the intensity of high-frequency competition for some stocks but not for others. I find that otherwise similar stocks subject to more high-frequency trading competition become less liquid. JEL Classification: G23, D4

Suggested Citation

  • Breckenfelder, Johannes, 2020. "How does competition among high-frequency traders affect market liquidity?," Research Bulletin, European Central Bank, vol. 78.
    • Handle: RePEc:ecb:ecbrbu:2020:0078:
    Note: 1125999
    as

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    References listed on IDEAS

    as
    1. Albert J. Menkveld & Marius A. Zoican, 2017. "Need for Speed? Exchange Latency and Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 30(4), pages 1188-1228.
    2. Xuan Tao & Andrew Day & Lan Ling & Samuel Drapeau, 2020. "On Detecting Spoofing Strategies in High Frequency Trading," Papers 2009.14818, arXiv.org, revised Dec 2020.
    3. Maureen O’Hara & Gideon Saar & Zhuo Zhong, 2019. "Relative Tick Size and the Trading Environment," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 9(1), pages 47-90.
    4. Chen Yao & Mao Ye, 2018. "Why Trading Speed Matters: A Tale of Queue Rationing under Price Controls," The Review of Financial Studies, Society for Financial Studies, vol. 31(6), pages 2157-2183.
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    Cited by:

    1. Steffen, Viktoria, 2023. "A literature review on extreme price movements with reversal," Journal of Behavioral and Experimental Finance, Elsevier, vol. 38(C).

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    More about this item

    Keywords

    competition; high-frequency trading; high-frequency trading strategies; tick size reform;
    All these keywords.

    JEL classification:

    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • D4 - Microeconomics - - Market Structure, Pricing, and Design

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