EQUILIBRIUM FAST TRADING

Tim Lu

Sep 09, 2015

Topics in Quantitative Finance

Washington University in St. Louis

OUTLINE

Introduction Model Specification The Equilibrium at Given Level of Fast Trading Endogenous Fast Trading Social Optimal Fast Trading and Policy Implication Conclusion

INTRODUCTION

Benefit of Fast Trading

Enhanced Quotes Search

Reduce the cost of delay or partial execution

Cost of Fast Trading

Access to Advanced Information of Fast Trader

Induce adverse selection for traders, which impose negative externalities on economy

MODEL SPECIFICATION

Asset Market Investors Valuation Trading

EQUILIBRIUM GIVEN FAST TRADING LEVEL

Equilibrium Spread: Exist Unique Stable Spread(question) Increase with the level of fast

trading

Equilibrium Volume Fast Institutions trade more

because of searching advantage; trade more or less because of information advantage

Under some conditions, fast institutions trade more

An increase in fast trading increase fast institutions, at the same time increase spread

ENDOGENOUS FAST TRADING

The decision of being fast or slow depends on the relative value of being fast. Being slow has a cost of delayed execution while being fast has both search and speculation value. Equilibrium exists and is higher than 0 under some condition.

Strategic Substitute or Strategic Complement depends on the marginal relative benefit with regard to an increase in the level of fast trading. When the level of fast trading increases, spread increases so fast institutions’ profit decreases, however, slow institutions’ profit may decrease more

SOCIAL OPTIMAL FAST TRADING

Compare Social Cost with Social Benefit Social cost includes tech cost and negative externality cost Social benefit comes from fast execution

There Exists Overinvestment, Especially under Complementary in Institutions’ Decisions

Solutions: Pigovian Tax Separate Markets Banning Fast Trading

CONCLUSION

Fast trading has value Fast trading has private cost and social cost(negative externality) Overinvestment is more acute when institutions’ investment

decisions are strategic complements Pigovian tax can lead fast trading to social optimal level The tax should be carefully devised to tax easily observable

investments(colocation, fiber-optic cables)

MY QUESTION

The author assumes the market makers are risk neutral with no private information, and the market for market maker is competitive or monopolistic competition(with 0 profit). In reality, the market maker(broker-dealer firm) is most likely also a high frequency firm; while there is significant barriers to entry both from up-front investment as well as regulation.

YOUR QUESTIONS?

THANK YOU FOR YOUR TIME!