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The Welfare Effects of Financial Innovation: High-Frequency Trading in Equity Markets

Author

Listed:
  • Thomas Philippon

    (NYU Stern)

  • Emiliano S. Pagnotta

    (NYU Stern)

Abstract

The financial crisis has demonstrated the need to better analyze financial innovations. While some of these innovations are beneficial, others do not improve overall welfare and create unacceptable risks for the economy. A major impediment to efficient regulation is the lack of research assessing the social value of financial innovations. In this paper we aim to provide a comprehensive analysis of high frequency trading (HFT) in equity markets. HFT is an important innovation whose social value is open to heated debate. Understanding its consequences is key to evaluate the impact of equity trading on economic activity, but also to assess whether ultra-fast computerized trading may affect a market’s systemic stability. We develop a dynamic model of trading activity with heterogeneous trading technologies and derive testable welfare implications. In order to quantify the costs and benefits of HFT, we exploit a proprietary NASDAQ dataset that allows us to observe the actions of the innovators (high frequency traders) and study their effect on market aggregates and other participants’ investment decisions. Besides equity markets, we expect that our analysis will prove useful to anticipate impacts in a much larger class of assets for which HFT is or will become increasingly important, like derivative markets, and for studying financial innovation more broadly.

Suggested Citation

  • Thomas Philippon & Emiliano S. Pagnotta, 2011. "The Welfare Effects of Financial Innovation: High-Frequency Trading in Equity Markets," 2011 Meeting Papers 1246, Society for Economic Dynamics.
    • Handle: RePEc:red:sed011:1246
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    References listed on IDEAS

    as
    1. Miller, Merton H., 1986. "Financial Innovation: The Last Twenty Years and the Next," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(4), pages 459-471, December.
    2. Burton Hollifield & Robert A. Miller & Patrik Sandås & Joshua Slive, 2006. "Estimating the Gains from Trade in Limit‐Order Markets," Journal of Finance, American Finance Association, vol. 61(6), pages 2753-2804, December.
    3. Robert C. Merton, 1992. "Financial Innovation And Economic Performance," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(4), pages 12-22, January.
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