Keynote Talk

Abstract

The first part of this talk will cover the argument in Budish, Cramton and Shim [1] that the predominant design used by financial exchanges around the world, called the continuous limit order book, is flawed. The flaw - essentially, a glitch introduced in the transition from human-based financial exchanges to electronic ones - is to treat time as a continuous variable, and process requests to trade serially. This combination of continuous time and serial processing creates mechanical arbitrage opportunities based on symmetric public information --- a violation of efficient markets theory, built right into the design! --- which in turn harms liquidity provision and induces a never-ending, socially wasteful, arms race for speed. That is, much of high-frequency trading is a symptom of flawed design. We propose an alternative design, called frequent batch auctions, in which time is discrete and orders are batch processed using auctions, and show that this directly fixes the problem with the continuous The second part of this talk will ask whether the market will fix the market? that is, whether forces will lead to the adoption of discrete-time trading instead of continuous-time trading, or whether a regulatory intervention would be needed. This requires a model of how modern stock exchanges compete and earn profits, the subject of new work-in-progress with Lee and Shim [2]. The model shows that competition among stock exchanges is fierce on the dimension of traditional trading fees, but that exchanges have power in the sale of exchange-specific speed technology - i.e., arms for the arms race. We then use the model to study the private and social returns to design innovation. We find that even though the social returns to adopting discrete-time trading would be large and positive, the private returns can be negative, due to the loss of rents from speed technology. We discuss some modest policy interventions that could tip the balance of incentives and encourage the market to fix the market. Last, I will discuss some open questions about financial design that lie at the intersection of economics and computer science. [1]Budish, E, P. Cramton and J. Shim. 2015. The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response. Quarterly Journal of Economics, pg. 1547-1621. [2]Budish, E, R. Lee and J. Shim. 2018. Will the Market Fix the Market? A Theory of Stock Exchange Competition and Innovation. Manuscript in Preparation.