Abstract
This paper investigates the impact of market-wide low latency trading technologies on informational asymmetries between traders. It develops a model with two types of high-frequency traders: market makers (HFT-M) and ”bandits” (HFT-B), who profit by trading on stale quotes. The HFTs endogenously decide on information acquisition. Competitive HFT market-makers face higher adverse selection risks when latency drops, as the conditional probability of a liquidity motivated trade decreases. In equilibrium, they will charge higher spreads to compensate for the additional risk. Lower market latencies also provide incentives for market makers to gather information. Informed market makers reduce expected losses on stale quotes while still attracting liquidity demand from uninformed traders. We find empirical support for the model implications: the adverse selection component of the bid-ask spread increases by 15% (0.35 bps) on NASDAQ OMX after introducing low-latency technology. The effect is stronger in more volatile securities.
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