DP15848 Intermediation and Price Volatility

Author(s): Thomas Gehrig, Klaus Ritzberger
Publication Date: February 2021
Date Revised: February 2021
Keyword(s): High-frequency trading, intermediation, market design, Price volatility
JEL(s): D43, D47, G14, L13
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15848

This paper analyses the role of intermediaries in providing immediacy in fast markets. Fast markets are modelled as contests with the possibility of multiple winners where the probability of casting the best quote depends on prior technology investments. Depending on the market design, equilibrium pricing by intermediaries involves a trade-off, between monopolistic price distortion and excess volatility. Since equilibrium at the pricing stage generates an externality, investments into faster trading technologies are necessarily asymmetric in equilibrium, akin to markets with vertical product differentiation. Further, equilibrium is not necessarily effcient, since it is possible that a high-cost intermediary ends up investing excessively and thus trades more frequently than low-cost rivals.