Profitability and Market Quality of High Frequency Market-Makers: An Empirical Investigation

Abstract

Financial markets in contemporary regulatory settings require the presence of high-frequency liquidity providers. We present an applied study of the profitability and the impact on market quality of an individual high-frequency trader acting as a market-maker. Using a sample of sixty stocks over a six-month period, we implement the optimal quoting policy (OQP) of liquidity provision from Ait-Sahalia and Saglam's (2014) dynamic inventory management model. The OQP allows the high-frequency trader to extract a constant annuity from the market but its profitability is insufficient to cover the costs of market-making activities. The OQP is embedded in a trading strategy that relaxes the model’s constraint on the quantity traded. Circuit-breakers are implemented and market imperfections are considered. Profits excluding maker-fees and considering transaction fees are economically significant. We propose a methodology to adjust the returns for asynchronous trading and varying leverage levels associated with dynamic inventory management. This allows us to qualify high trade volume as a proxy of informed trading. The high-frequency trader behaves as a constant liquidity provider and has a positive effect on market quality even in periods of market stress.