November 29, 2011, 11:00–12:30
Toulouse
Room MF 323
Economic Theory Seminar
Abstract
High Frequency Trading (HFT) improves investors' ability to seize trading opportunities, which raises gains from trade. It also enables fast traders to process information before slow traders, which generates adverse selection. We first analyze trading equilibria for a given level of HFT and then endogenize investment in HFT. When some traders become fast, it increases adverse selection costs for the others, thus HFT generates negative externalities. Therefore equilibrium investment in HFT exceeds its utilitarian welfare maximizing counterpart. Furthermore, since it involves fixed costs, investment in HFT is more profitable for large institutions than for small ones. Hence, in equilibrium, small institutions are less informed than large ones and exit the market when HFT becomes prevalent.