A new paper that examines the impact of high-frequency trading (HFT) finds that the first few HFT traders to enter the market help enhance market quality as they compete for volume, but that these effects diminish as they number of HFTs grow — ultimately, they end up competing to eat one another’s lunch.
A new working paper published Monday by the Bank of Canada looks at the phenomenon of competition between high-frequency traders based on data from the alternative trading venue, Alpha, between 2008 and 2012. It finds that as new HFTs enter the market they disturb the trading environment and push existing HFT firms to adapt, as they lose volume to the new competitors. These adaptations suggest enhanced market quality.
For example, it finds that when so-called “passive” HFT firms, which mainly provide liquidity, enter the market, existing firms tighten their spreads. And when “aggressive” HFT firms, which mainly take liquidity, enter the market, incumbent firms see their informational disadvantage diminish as they “experience a loss in their ability to trade in the direction of future price movements”; which suggests markets are becoming more efficient.
The arrival of each new competitor also means that the existing firms earn less revenue, the paper finds. And, it notes that all of these effects diminish as the number of firms entering the market increases.
“Later-arriving entrants have less of an impact than earlier arrivals,” it says. “After a third HFT begins trading a stock, the HFT share of volume and trades, the competitive pressure on HFT quoted spreads and trade informedness, and HFT revenues lose statistical significance.”
“Later entrants do not generate new business for HFT but do significantly displace incumbents,” it observes; adding that although the arrival of more than three HFTs does not generate any new business for HFT, new traders continue to enter the fray.