nep-mst New Economics Papers
on Market Microstructure
Issue of 2019‒05‒27
four papers chosen by
Thanos Verousis
University of Essex

  1. The Design and Regulation of High Frequency Traders By Daniel Ladley
  2. Cointegration in high frequency data By Simon Clinet; Yoann Potiron
  3. Discriminatory Pricing of Over-the-Counter Derivatives By Harald Hau; Peter Hoffmann; Sam Langfield; Yannick Timmer
  4. Will the Market Fix the Market? A Theory of Stock Exchange Competition and Innovation By Eric Budish; Robin S. Lee; John J. Shim

  1. By: Daniel Ladley
    Abstract: Central to the ability of a high frequency trader to make money is speed. In order to be first to trading opportunities fi rms invest in the fastest hardware and the shortest connections between their machines and the markets. This, however, is not enough, algorithms must be short, no more than a few lines of code. As a result there is a trade-off in the design of optimal HFT strategies: being the fastest necessitates being less sophisticated. To understand the effect of this tension a computational model is presented that captures latency, both of code execution and information transmission. Trading algorithms are modelled through genetic programmes with longer programmes allowing more sophisticated decisions at the cost of slower execution times. It is shown that depending on the market composition short fast strategies and slower more sophisticated strategies may both be viable and exploit different trading opportunities. The relative pro fits of these different approaches vary, however, slow traders bene t from their presence. A suite of regulations are tested to manage the risks associated with high frequency trading, the majority are found to be ineffective, however, constraining the ratio of orders to trades may be promising.
    Keywords: Finance, Genetic Programming, High Frequency Trading, Strategy Design, Regulation
    Date: 2019–03
  2. By: Simon Clinet; Yoann Potiron
    Abstract: In this paper, we consider a framework adapting the notion of cointegration when two asset prices are generated by a driftless It\^{o}-semimartingale featuring jumps with infinite activity, observed synchronously and regularly at high frequency. We develop a regression based estimation of the cointegrated relations method and show the related consistency and central limit theory when there is cointegration within that framework. We also provide a Dickey-Fuller type residual based test for the null of no cointegration against the alternative of cointegration, along with its limit theory. Under no cointegration, the asymptotic limit is the same as that of the original Dickey-Fuller residual based test, so that critical values can be easily tabulated in the same way. Finite sample indicates adequate size and good power properties in a variety of realistic configurations, outperforming original Dickey-Fuller and Phillips-Perron type residual based tests, whose sizes are distorted by non ergodic time-varying variance and power is altered by price jumps. Two empirical examples consolidate the Monte-Carlo evidence that the adapted tests can be rejected while the original tests are not, and vice versa.
    Date: 2019–05
  3. By: Harald Hau; Peter Hoffmann; Sam Langfield; Yannick Timmer
    Abstract: New regulatory data reveal extensive price discrimination against non-financial clients in the FX derivatives market. The client at the 90th percentile pays an effective spread of 0.5%, while the bottom quarter incur transaction costs of less than 0.02%. Consistent with models of search frictions in over-the-counter markets, dealers charge higher spreads to less sophisticated clients. However, price discrimination is eliminated when clients trade through multi-dealer request-for-quote platforms. We also document that dealers extract rents from captive clients and market opacity, but only for contracts negotiated bilaterally with unsophisticated clients.
    Date: 2019–05–07
  4. By: Eric Budish; Robin S. Lee; John J. Shim
    Abstract: Will the market adopt new market designs that address the negative aspects of high-frequency trading? This paper builds a theoretical model of stock exchange competition, shaped by institutional and regulatory details of the U.S. equities market. We show that under the status quo market design: (i) trading behavior across the many distinct exchanges is as if there is just a single “synthesized” exchange; (ii) as a result, trading fees are perfectly competitive; but (iii) exchanges capture and maintain significant economic rents from the sale of “speed technology” (i.e., proprietary data feeds and co-location)—arms for the high-frequency trading arms race. Using a variety of data, we document seven stylized empirical facts that suggest that the model captures the essential economics of how U.S. stock exchanges compete and make money in the modern era. We then use the model to examine the private and social incentives for market design innovation. We find that while the social returns to market design innovation are large, the private returns are much smaller and may be negative, especially for incumbents that derive rents in the status quo from selling speed technology.
    JEL: D02 D44 D53 D82 G1 G2 G23 L1 L13 L5 L89
    Date: 2019–05

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