Abstract
We analyze how liquidity provision by high-frequency traders (HFTs) affects market stability, echoing recent regulatory concerns. Our model features a limit order market with informed trading and endogenous entry and exit. Liquidity is provided by traditional liquidity providers and HFTs with superior speed and/or information processing technology. Speed technology by itself leads to efficient resource allocation and maximizes liquidity. Information processing technology by itself generates mild inefficiencies due to a lemons problem. Yet, the combination of the two can lead to the implementation of inefficient speed technology, oligopolistic rents, or an amplified lemons problem with occasional market freezes.
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