The Impact of High-Frequency Trading on Market Volatility

Abstract

Several studies have investigated the impact of High-Frequency Trading (HFT) on financial stability and volatility in particular. Albeit opinions differ, most findings lean into the direction of a beneficial HFT impact, leading to lower volatility. However, if the effect of HFT seems to be generally positive in normal times, it is far less clear how it affects volatility under stress, with some authors claiming a negative impact altogether. This paper presents the results of an Agent-Based Model simulation under two different cases: a quiet situation and a market following a trend. Whereas the quiet situation does not identify any abnormal behaviour, when the market is under stress the participation of High-Frequency (HF) traders leads to a statistically significant increase of volatility. The result can be explained with the delay suffered by market orders posted by low-frequency traders during a trend. Quite often they are executed at a price which, because of its rapid movements, is worse than intended when it was posted a few milliseconds earlier, with the effect of increasing volatility. As the number of HF traders increases, volatility starts to diminish again. This can be explained with the more homogeneous situation when most trading is executed by players experiencing similar latencies.