Latency, Liquidity and Price Discovery

Abstract

The speed of trading is an important factor in modern security markets. We still know relatively little about the e ffect of speed on liquidity and price discovery, two important aspects of market quality. On April 23rd, 2007, Deutsche Boerse made the most important upgrade to their trading system since 2002. With the 8.0 release of Xetra, system latency was reduced from 50 ms to 10 ms. Both quoted and eff ective spreads decreases post upgrade. This increase in liquidity, is due to dramatically lower adverse selection costs that are only partially translated into higher liquidity. We interpret this as a decrease in the competition between liquidity suppliers who are able to increase their revenues by more than 185 million Euros. The contribution of quotes to price discovery doubles to 90% post upgrade, indicating that prices are more effcient.