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IESE Research Papers,
IESE Business School

No D/1161: High Frequency Trading and Fragility

Giovanni Cespa () and Xavier Vives ()
Additional contact information
Giovanni Cespa: Cass Business School, City, University of London, Postal: 106 Bunhill Row, London EC1Y 8TZ
Xavier Vives: IESE Business School, Postal: IESE Business School. Research Division, Av Pearson 21, 08034 Barcelona, SPAIN

Abstract: We show that limited dealer participation in the market, coupled with an informational friction resulting from high frequency trading, can induce demand for liquidity to be upward sloping and strategic complementarities in traders' liquidity consumption decisions: traders demand more liquidity when the market becomes less liquid, which in turn makes the market more illiquid, fostering the initial demand hike. This can generate market instability, where an initial dearth of liquidity degenerates into a liquidity rout (as in a flash crash). While in a transparent market, liquidity is increasing in the proportion of high frequency traders, in an opaque market strategic complementarities can make liquidity U-shaped in this proportion as well as in the degree of transparency.

Keywords: Market fragmentation; high frequency trading; flash crash; asymmetric information

JEL-codes: G10; G12; G14

48 pages, January 16, 2017

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