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A dynamic limit order market with fast and slow traders

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  • Hoffmann, Peter

Abstract

We study a dynamic limit order market where agents may invest into a trading technology that grants them a speed advantage over others. Being fast is valuable because it allows limit orders to be revised quickly in the light of new information and therefore reduces the risk of being picked off. Even though this can generate more trading, the equilibrium level of investment is excessive and always generates a welfare loss because fast traders exert negative externalities on slow agents and are able to extract any surplus. If the diffusion of trading technology additionally leads to a more efficient trading process, this result may reverse completely. For sufficiently large efficiency gains, fast traders exert positive externalities on slow market participants and their presence leads to an increase in social welfare, albeit the equilibrium level of investment is below the social optimum. Our results imply that the marginal impact of investments related to algorithmic and high-frequency trading on social welfare crucially depends on the pre-investment level of market efficiency.

Suggested Citation

  • Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 39855, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:39855
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    References listed on IDEAS

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    5. Menkveld, Albert J., 2013. "High frequency trading and the new market makers," Journal of Financial Markets, Elsevier, vol. 16(4), pages 712-740.
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    Citations

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    Cited by:

    1. Nidhi Aggarwal & Susan Thomas, 2014. "The causal impact of algorithmic trading on market quality," Indira Gandhi Institute of Development Research, Mumbai Working Papers 2014-023, Indira Gandhi Institute of Development Research, Mumbai, India.
    2. van Kervel, V.L., 2013. "Competition between stock exchanges and optimal trading," Other publications TiSEM 5c608a0f-527d-441d-a910-e, Tilburg University, School of Economics and Management.
    3. Menkveld, Albert J., 2013. "High frequency trading and the new market makers," Journal of Financial Markets, Elsevier, vol. 16(4), pages 712-740.
    4. Danny Lo, 2015. "Essays in Market Microstructure and Investor Trading," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 4-2015, January-A.

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    More about this item

    Keywords

    Algorithmic Trading; Limit Order Market; Welfare; Investment;
    All these keywords.

    JEL classification:

    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • G19 - Financial Economics - - General Financial Markets - - - Other
    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games

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