High Frequency Trading and Learning

Abstract

This paper introduces a limit order market model of fast and slow traders with learning to examine the effect of high frequency trading (HFT) and learning on limit order markets. We demonstrate that informed HFT makes significant profit from trading with other traders and, more importantly, it is the learning and information advantage that plays more important role than the trading speed in generating HFT profit. Overall HFT increases market liquidity consumption and supply, trading volumes, bid-ask spread, volatility and order cancellations, reduces order book depth, improves information dissemination efficiency, and generates significant event clustering effect in order flows. Interestingly, the speed of HFT is positively related to trading volume and spread and negatively related to market depth; however it has an U-shaped relation to liquidity supply and market efficiency, but an invert U-shaped relation to HFT profit and liquidity consumption. The findings provide some insight on the profitability of HFT and the current debates and puzzles about HFT.