The Externalities of High Frequency Trading

Abstract

When price competition is constrained by tick size, speed allocates the resources due to the time priority rule. We demonstrate three implications of competition in speed. 1) We find more high frequency liquidity provision for lower price stocks with high market cap, where the one cent tick size has a higher constraint on price competition. 2) Speed has no impact on (the price) of liquidity, because speed competition already implies that liquidity providers cannot undercut each other’s price. We find that exogenous technology improvements improving speed at a one millisecond, microsecond or nanosecond level do not lead to improvements on quoted spread, effective spread, trading volume or variance ratio. However, the cancellation/execution ratio increases, short term volatility increases and market depth decreases. 3) It is relative speed that matters. We find evidence consistent with the quote stuffing hypothesis (Biais and Woolley, 2011) using NASDAQ channel assignment as identification. Competition in speed but not price leads to externalities based on the canonical definition of Laffont (2008). One possible policy solution is the deregulation of tick size or decrease the importance of time priority.