DP11732 High Frequency Trading and Fragility

Author(s): Giovanni Cespa, Xavier Vives
Publication Date: December 2016
Keyword(s): asymmetric information., flash crash, high frequency trading, market fragmentation
JEL(s): G10, G12, G14
Programme Areas: Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11732

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.