The Externality of High Frequency Trading

Abstract

We show that two exogenous technology shocks that increase the speed of trading from microseconds to nanoseconds do not lead to improvements on quoted spread, effective spread, trading volume or variance ratio. However, cancellation/execution ratio increases dramatically from 26:1 to 32:1, short term volatility increases and market depth decreases. We find evidence consistent with “quote stuffing,” which involves submitting an extraordinarily large number of orders followed by immediate cancellation in order to generate order congestion. The stock data are handled by six independent channels in the NASDAQ based on alphabetic order of ticker symbols. We detect abnormally high levels of co-movement of message flows for stocks in the same channel using factor regression, a discontinuity test and diff-in-diff test. Our results suggest that an arms race in speed at the sub-millisecond level is a positional game in which a trader’s pay-off depends on her speed relative to other traders. This game leads to positional externality (Frank and Bernanke, 2012), in which private benefit leads to offsetting investments on speed, or effort to slow down other traders or the exchange, with no observed social benefit.