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High frequency market making during stressed periods

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  • Xu, Ke

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.

Suggested Citation

  • Xu, Ke, 2023. "High frequency market making during stressed periods," International Review of Economics & Finance, Elsevier, vol. 87(C), pages 379-397.
    • Handle: RePEc:eee:reveco:v:87:y:2023:i:c:p:379-397
    DOI: 10.1016/j.iref.2023.05.001
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    Cited by:

    1. Ge, Hengshun & Yang, Haijun & Doukas, John A., 2024. "The optimal strategies of competitive high-frequency traders and effects on market liquidity," International Review of Economics & Finance, Elsevier, vol. 91(C), pages 653-679.

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    More about this item

    Keywords

    High frequency trading; Market making; Adverse selection; Price discrimination; Speed limit policy;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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