Abstract
This paper proposes a theoretical model of the competition among high-frequency traders and its impact on market liquidity. First, the optimal strategies of high-frequency market-makers and corresponding effects are explored. Then two-sided quotes and high-frequency speculators are introduced to enrich our model. Furthermore, we calculate the equilibrium in steady-state and analyze parameters in the equilibrium. The empirical results, consistent with the predictions of our model, show that a lower exchange latency leads to a lower bid-ask spread and the market maker's preference for a two-sided quote. In addition, the speed and information advantages of the market-maker are beneficial to liquidity, while speculators consume liquidity. Furthermore, we employ intra-day data of OMXC20 and three major currency pairs (EUR/USD, USD/JPY, and GBP/USD) in the forex market to verify the predictions of our model.
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