The Impact of High-Frequency Trading in Experimental Markets

Abstract

The impact of high-frequency trading (HFT) strategies on market quality has been debated in both public forums and academic studies for years. Although some consider HFT to be inherently bad, others view it as providing important liquidity to markets. Thus, the question regarding HFT’s impact on market quality remains open. To address this, the authors conducted two sets of controlled laboratory experiments, one with and one without an HFT robot trader. The authors focus on two aspects of HFT trading strategies that have the potential to affect market quality negatively: arbitrage and directional trading. Indeed the authors designed the HFT robot to have a perfect view of the market before executing a trade to provide it the best chance to influence the market. The introduction of this HFT robot had a significant positive impact on trading volume and bid depth, but it had a negligible impact on other market quality indicators such as efficiency, price volatility, bid-ask spread, and book depth. Thus, the authors find that in this polar case, HFT is neither a drain on nor a boost to market quality, suggesting that HFT trading, in its worst case, has a benign effect on the market. <b>TOPICS:</b>Futures and forward contracts, portfolio construction, portfolio theory <b>Key Findings</b> • We seek to examine the effect of high-frequency trading on market quality using controlled laboratory experiments. • We find no statistically significant effects for most measures of market quality when we introduce high-frequency trading. The only measures that are affected by high-frequency trading are trading volume and bid depth. • High-frequency traders are effective middlemen and invoke a response from traders in terms of bidding behavior.