Algorithmic and High Frequency Trading in Dynamic Limit Order Markets

Abstract

OVERVIEW We consider a dynamic equilibrium model of algorithmic trading (AT) for limit order markets. We show that AT improves market performance ‘only’ under specific conditions. For instance, AT traders with only an informational (only a trading speed) advantage increase (reduce) global welfare. AT traders act as liquidity demanders with ‘predatory’ strategies when ‘lessskilled’ investors are majority, which may deteriorate liquidity and welfare. AT reduces waiting costs but finally damages traditional traders’ profits and changes their trading behaviour. AT traders prefer volatile assets, and we report that cancellation fees may be better policy instruments to control AT activity than latency restrictions. BIOGRAPHY Dr Bernakes’s research is focused on market microstructure, inter-bank markets, asset pricing, derivatives markets, dynamic equilibrium models, rational learning, and asymmetric information. In 2014, he will be awarded The International Finance and Society (IFABS) 2014 Fellowship award in Lisbon for the new project Banking Dynamics and Systemic Risk and has been invited by Banque de France as a Visiting Scholar in 2014 at the Banque de France headquarter in Paris.