A Model of Strategic High-Frequency Trading and For-Profit Exchanges with Intentional Delays

Abstract

This paper studies competition between strategic high-frequency traders (HFTs) and multiple for-profit exchanges. In the model, HFTs play a dual role as liquidity snipers and market makers and strategically decide on their trading venue, the intensity of market monitoring, a bid-ask spread, and speed technologies. With the strategic liquidity provision and HFTs' dual role in the market, I show that the expected bid-ask spread can shrink when adverse selection becomes more severe. I also derive the HFTs' demand for speed services and demonstrate that it can be an increasing function of the length of intentional delays imposed on trade execution by exchange platforms (e.g., speed bumps). In the second part, for-profit exchanges try to maximize their revenues from supplying speed services to HFTs by controlling the speed of order execution. Since the demand for speed services can positively react to the intentional delays in order execution, exchanges are willing to introduce them to boost their profits. Thus the imposition of delays, which mitigates adverse selection and improves liquidity, is supported as an equilibrium outcome even without government intervention.