| Abstract: |
High-speed computerized trading, often called "high-frequency trading" (HFT),
has increased dramatically in financial markets over the last decade. In the
US and Europe, it now accounts for nearly one-half of all trades. Although
evidence suggests that HFT contributes to the efficiency of markets, there are
concerns it also adds to market instability, especially during times of
stress. Currently, it is unclear how or why HFT produces these outcomes. In
this paper, I use data from NASDAQ to show that HFT synchronizes prices in
financial markets, making the values of related securities change
contemporaneously. With a model, I demonstrate how price synchronization leads
to increased efficiency: prices are more accurate and transaction costs are
reduced. During times of stress, however, localized errors quickly propagate
through the financial system if safeguards are not in place. In addition,
there is potential for HFT to enforce incorrect relationships between
securities, making prices more (or less) correlated than economic fundamentals
warrant. This research highlights an important role that HFT plays in markets
and helps answer several puzzling questions that previously seemed difficult
to explain: why HFT is so prevalent, why HFT concentrates in certain
securities and largely ignores others, and finally, how HFT can lower
transaction costs yet still make profits. |