Middlemen in Limit-Order Markets 1

Middlemen in Limit Order Markets A limit-order market enables an early investor to trade with a late investor. But, p ublic news in the interarrival period creates adverse-selection cost and hampers trade. A high freq uency trader (HFT) might restore trade through its unique ability to quickly update its quote on news arrival. But, HFT e ntry might in itself worsen adverse selection if speed is used to adversely select investors’ quotes . This paper studies HFT entry both theoretically and empirically. The entry of an HFT-friendly new market is use d as an instrument. Middlemen arrival coincides with a 29% reduction in the bid-ask spread and a 13% dr op in volume. Technology revolutionized the way financial assets are traded. Electron ic limit order markets enable agents to automate trading decisions. Computer algorithms are used to either minimize transa ction cost when trading into position (‘working’ an order through time and across markets or o simply profit from buying and selling securities as a middleman. This latter type is the focus of our study an d is often referred to as high frequency trader (HFT). We study the advent of middlemen both theor etically and empirically. In principle, a limit order market removes the need for intermediation. Investo rs who are spaced out in time (due to a nontrivial opportunity cost of staying on in a market) establish trad es through limit orders. For example, an early investor with low private value for her asset might post a limit sell (‘ask quote’) which is taken up by a late investor with high private value for the asset. But, if there is common value process the late investor might adversely select the early investor (as she is better inf ormed). The early investor rationally posts a higher limit order to be compensated for this adverse selectio n cost. If common value innovations are large enough relative to private values the market hits a no -tr de deadlock. Middlemen can enhance welfare as their speed advantage helps to ‘unlock ’ an adverse-selection induced trade deadlock. High frequency traders stand out by their superior inf ormation processing speed established through efficient algorithms that run on fast computers ‘co-located’ at a market’s ser ver. This creates an edge in terms of quickly updating limit orders on the arrival of public information. In the deadlock example, the early investor might sell to the middleman who keeps refreshing his limit sell until th e la e investor arrives. Middlemen might reduce welfare if their speed creates an adverse selection risk for limit order that might not have otherwise existed. If the late investor is unaware of a common value inno vation, trade is not hampered by adverse selection. If middlemen are introduced in this setting, they create a n dverse selection risk for the early investor and might reduce trade. The theory develops the arguments for and against middlemen formally. It ad ds to a vast literature on market intermediation. Classic models in financial economics assume information asymmetry wh re, rather than superiorly informed, middlemen are uninformed which was natural for marke ts where humans intermediate (see, e.g.,Glosten and Milgrom (1985) andKyle (1985) . Foucault, Röell, and Sandas (2003) introduce costly monitoring ability for liquidity suppliers and analyze optimal intensity. More r ecent limit order models analyze how adverse selection risk a ffects the choice of an arriving agent to choose between a limit and a market order (see, e.g., Hollifield, Miller, Sandås, and Slive (2006) andGoettler, Parlour, and Rajan (2009) . They do not consider the entry of middlemen.