Trading Speed Competition: Can the Arms Race Go Too Far?

Abstract

We analyze the likelihood of arms race behavior in markets with liquidity provision by HFTs. Liquidity providers (makers) and liquidity consumers (takers) make costly investments in monitoring speed. Competition among makers and takers induces arms race behavior. However, trade success probabilities increase in monitoring speed, giving rise to complementarity externalities between makers and takers. This counters negative arms race effects. Whether arms race effects materialize crucially depends on how marginal gains from trade depend on transaction speed. With the common (often implicit) assumption of constant marginal gains from trade, complementarity effects mostly dominate and market participants tend to under-invest in technology. However, with marginal gains from trade that decline in transaction speed, arms race behavior is much more likely. We provide micro-foundations for declining marginal gains from trade by a dynamic portfolio optimization problem with random rebalancing opportunities.